The hard part begins

The low-hanging fruit has all been picked. Now comes the hard part for investors looking for cash flow.

Making money on income securities for the past two years has been as easy as finding snow in February. That’s because most people did not grasp the values available in high-grade income trusts until late in the game. Perhaps that was due to the bad after-taste that lingered following the federal government’s 2006 decision to tax the trusts. Whatever the reason, there were some incredible bargains to be found in the sector during 2009 and much of 2010 as the trusts announced their post-tax plans (it went into effect on Jan. 1 of this year). Those that declared their intention to maintain distributions at existing levels were richly rewarded as their shares moved sharply higher. We recommended several of these in my Income Investor newsletter, creating what we called a “Survivor Trust Portfolio”.

But now the rest of the market finally caught on. The prices of all the securities in the Survivor Portfolio were bid up, in some cases by more than 50%, and yields dropped accordingly. For example, Crescent Point Energy was yielding 10.3% when we advised buying it in March 2009. Since then, the price has increased by 65% and the yield has fallen to 6.2%. Atlantic Power, which was recommended in November 2009, has seen an increase of 54% in the share price and a corresponding drop in the yield from 10.9% to 7.1%. It’s a similar story for almost all the securities in the Survivor Portfolio.

As we search for new income choices, there are several points that investors should keep in mind, as follows:

Yields will be lower. The days when we could find good-quality securities yielding 10% and more are over. Now, 5% to 6% will be normal for an income security with average risk while higher-risk securities will be in the 7% to 9% range.

Prospective increases will be count for more. Investors are going to have to look more closely at securities with relatively low current yields but a history of dividend increases. The yields, based on the original price, will steadily increase over time. Canadian National Railway is a case in point. When it was recommended in the newsletter in October 2005, the stock was yielding only 1.2%. But CN’s history of steady dividend hikes meant that investors would enjoy increasing cash flow over the years. That’s the way it has worked out; the dividend has been raised six times since the recommendation and anyone who bought at the original price will receive a cash yield of 3.1% this year.

After-tax returns will be more significant. Although many income trusts reduced their distributions when they converted to a corporation, the fact that the payments are now eligible for the dividend tax credit has eased or eliminated the financial blow in taxable accounts. Going forward, income investors should be on the lookout for tax-advantaged securities for non-registered plans, although they won’t provide any advantage if held in RRSPs, RRIFs, or TFSAs.

Distributions must be dependable. Don’t invest in any income security unless you are confident that the distributions/dividends are secure. Of course, there are no guarantees — a sudden, sharp plunge in the price of oil, for example, could force energy companies to temporarily reduce payments. But always seek to minimize that risk by focusing on securities with a low payout ratio.

Of course, you should continue to apply the basic fundamentals of securities selection: a sound business, quality management, strong balance sheet, growing revenue and cash flow, and profitability.

There are still opportunities out there. It’s just going to take a little more work to find them.

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Photo © Tommaso Colia