The New Dividend Stars
01/17/2011 5:44 pm EST
A rising stock market has pushed many of blue-chip dividend stocks higher in price, and that’s caused their yields to fall to levels that won’t generate any excitement at all for income seekers who have money to invest. One way to get higher yields is to identify the blue chips you like and wait for their share prices to fall (prices and yields move inversely). Another is to look for alternatives in an emerging class of income stock we’re calling the high-yield corporation.
High-yield corporations are former income trusts that have converted into a conventional corporate structure. In their handling of this transition, many companies have shown qualities that suggest they have the makings of first-rate dividend stocks.
The story begins back on Halloween 2006, when the federal government smacked down the fast-growing trust sector by announcing that a new tax on trust distributions would take effect in 2011. It was immediately clear that trusts as a popular asset class had no long-term future in their existing form. The only question was what the impact on investors would be when they converted into corporations.
Remember, the point of a trust was to pay virtually all of its earnings to shareholders through monthly or quarterly distributions. Corporations don’t operate that way—they have to pay taxes (trusts largely paid little in taxes to Ottawa) and they have to keep money aside to build the business.
As it turns out, there’s very good news coming from the high-yield corporations emerging from their previous trust structure, and from a remnant of trusts that aren’t converting.
A dozen or so members of this combined group have increased payouts over year-ago levels. Some 40 have announced plans to maintain their cash payouts to shareholders in 2011 without any cuts, and another 40 or so have cut payouts by varying amounts.
On an after-tax basis in non-registered accounts, the news is even better. Prior to Jan. 1, income trust distributions were taxed in large part as regular income and, to a lesser extent, a return of capital. Cash payouts from high-yield corporations are classified as dividends, which means you get the benefit of the dividend tax credit. In simple terms, $1 in dividends is worth more on an after-tax basis than $1 in distributions from the typical trust pre-2011.
With the help of Harry Levant, an independent analyst who followed income trusts for years and put forward the term “high-yield corporation,” we’re going to zero in on the former trusts that turned themselves into corporations without taking a cent away from shareholders.
This feat addresses the top concern investors should have about investing in high-yield corporations: Can these companies keep the cash coming on schedule or, like many income trusts did, will they at some point have to cut or suspend their dividends?
Mr. Levant says high-yield corporations that maintain their former level of distributions have shown the ability to effectively manage their cash flow and thus can be considered reliable income producers.
“Looking out 12 to 24 months, I would have a high degree of confidence that their distributions will be stable,” said Mr. Levant, who follows the universe of income-producing stocks on his IncomeResearch.ca Web site.
Back on Oct. 31, 2006, when Finance Minister Jim Flaherty announced the trust tax, there were roughly 242 trusts listed on the Toronto Stock Exchange. Mr. Levant says about 75 trusts went private or were taken over, while 40 or so either suspended distributions or converted into corporations early on. That left him with 127 high-yield corporations, income trusts, real estate investments (REITs) and other high-yielding entities that don’t fit any of these categories. Note: Most REITs are exempt from the trust tax.
Let’s focus first on high-yield corporations and trusts that are increasing payouts to shareholders. Mr. Levant identified a dozen names in this group: Carfinco Income Fund (Toronto: CFN.UN), Canadian Energy Services & Technology (Toronto: CEU.TO), Canfor Pulp Products (Toronto: CFP), Westshore Terminals (Toronto: WTE.UN), Baytex Energy (Toronto: BTE), Boyd Group Income Trust (Toronto: BYD.UN), Bonterra Energy (Toronto: BNE), Labrador Iron Ore Royalty (Toronto: LIF.UN) Ag Growth International (Toronto: AFN) A&W Revenue Royalties Income Fund (Toronto: AW.UN), Brookfield Infrastructure Partners LP (NYSE: BIP), and Brookfield Renewable Power Fund (Toronto: BRC.UN).
Not surprisingly, all members of this group have been strong performers in the past year. Twelve-month price changes range from about 10% for Brookfield Renewable Power to more than 220% for Carfinco Income Fund.
Still, yields remain attractive when compared to what blue-chip dividend stocks offer. The average yield for the 12 high-yield corporations and trusts increasing their payouts this year was 5.4% as of late this week. Canfor Pulp Products was at the high end with a yield of 9.5% and Labrador Iron Ore Royalty was lowest with a yield of 2.8%.
If you were to do some yield-hunting in the S&P/TSX 60 index (big blue-chip stocks only), you’d find just four names with yields above 5%. One is Yellow Media (Toronto: YLO), a former trust that has worked a distribution cut into its corporate conversion plan, while another is the converted trust Enerplus Corp. There is also BCE Inc., which in the past couple of years has developed into a solid dividend growth stock, and TransAlta Corp., which sporadically raises its dividend.
Not all the trusts that are increasing or maintaining distributions can be considered suitable for conservative income seekers. Take Carfinco, for example. It’s in the business of financing new car purchases and it has had a lot of ups and downs in its distributions over the years. Boyd Group, which is in the automotive collision repair business, has a similar history. Mr. Levant noted that Westshore and Labrador have variable payout policies and their 2011 level of payout represents his forecast, not that of the companies.
To help conservative income-seeking investors make their way through the post-trust landscape, I asked Mr. Levant for some premium names. He offered a list of 14 larger companies and trusts, and three smaller choices that he considers to be well run. All are either increasing or maintaining payouts to shareholders this year. This list is below. (For a full list of former trusts, remaining trusts and real estate investment trusts, and how their distributions will change in 2011 versus last year, click here)
A lot of money has poured into newly created high-yield corporations already—you can see that by the share price gains posted by many of them. What will life be like with these stocks once they become familiar to investors?
Mr. Levant believes they’ll primarily become income investments, although share price growth is not out of the question. Dividend increases will be possible, as well. Still, he warns that investors must recognize that the new, emerging class of high-yield corporations do not have the same long track record of stable dividends as the old standby blue-chip dividend stocks.
“We are looking at a higher risk level,” he said.