Revenge of the Income Trusts

07/10/2012 4:17 pm EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

It's been six years since Finance Minister Jim Flaherty's infamous "Halloween Massacre" and nearly two years since income trusts' long-feared January 1, 2011 date of execution. But dozens of the current and former trusts are still paying monthly dividends that are among the highest in the world—and tax advantaged for Canadian investors as well.

The Tax Fairness Act of 2007 eliminated income trusts and limited partnerships’ ability to avoid paying corporate taxes starting in 2011. But it didn’t prevent companies from sticking to a dividend-paying model based on actual cash flow, rather than conventional earnings per share.

Despite paying higher taxes, the vast majority of income trusts that converted to corporations—and all of those that stayed trusts—have continued to pay from cash flow. As a result, most pay as much or more today in dividends than they did back in 2006 when the trust tax was first announced.

The other big surprise coming out of 2011 is the superior total return posted by income trusts since 2006. The initial market reaction to the announcement of a trust tax was a two-week wipeout of more than $20 billion in shareholder value, dubbed the “Halloween Massacre.” Then came the crash of 2008, which dwarfed those losses, as the S&P Toronto Stock Exchange Trust Composite Index (SPRTCM) lost more than half its value in a few months.

But even with those traumatic events, the SPRTCM income trust index has more than doubled investor wealth since Halloween night 2006. That’s more than ten times the return on the S&P 500 index. And even higher than the gains for US master limited partnerships, which have retained their favorable tax status in the US over that time.

That return was helped by takeovers of several dozen trusts in early 2007, before tightening credit markets choked off private capital’s buying spree. The mammoth gains we saw in 2009, 2010 and 2011, however, flowed from management decisions to maintain all or most of their dividends despite absorbing new taxes.

Some dramatically exceeded expectations. For example, energy midstream company Keyera Corp (TSX: KEY, OTC: KEYUF) has returned more than 250 percent since Halloween 2006 and has increased its dividend six times.

Of course, not every former income trust has prospered since Halloween night 2006. Arctic Glacier (TSX: AG-U, OTC: AGUNF) has all but wiped out unit holders in its long slide toward insolvency and is now almost entirely owned by its creditors. That also appears to be where once-popular Yellow Media (TSX: YLO, OTC: YLWPF) is headed.

Both companies’ woes, however, were entirely due to problems at their underlying businesses that they were unable to overcome. The trusts that stayed strong underneath and kept faith with shareholders on dividends have been some of the best income investments around for the past six years.

There are still plenty of gainsayers. Some bears maintain companies simply can’t pay a big dividend and maintain a solid business, let alone grow one. They just don’t understand that the discipline of paying dividends can actually improves efficiency of capital budgets, as the trusts have proved time and again.

Others simply can’t get their minds around a company for which earnings per share under Generally Accepted Accounting principles are meaningless. And still others seem to be waiting for another shoe to drop on taxation, even for companies that are now bona fide taxable corporations.

The result is many big dividend paying Canadian stocks continue to trade at sizeable discounts to conventional corporations, even when they’re growing faster. That gap isn’t likely to narrow while investors are fixated on risks to the global economy, and generally avoiding anything off a very well beaten path.

But so long as companies do stay healthy as businesses, investors can look forward to big capital gains as well as high yields from holding them. And that’s a huge opportunity in any market that shouldn’t be missed.

Roger S. Conrad is founding editor of Canadian Edge, an advisory providing buy/hold/sell advice for more than 160 high yielding Canadian stocks for both conservative and aggressive investors. Hulbert Financial Digest recently named his Utility Forecaster advisory the top performing investment newsletter for the past 10-years for risk-adjusted returns.

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