How To Pick High-Caliber Income Trusts (Version 1)
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Folks, I’m on a quest to nail down a checklist for income trust investing. The checklist itself is an evaluation, and one reason for this post is to solicit your feedbacks and hopefully morph the list into something functional.
The unfortunate reality is that our Canadian common share market is quite narrow when it comes to selections, but the income trust market opens a door to a new dimension of diversification. I maintain a small watch list of income trusts, and it’s quite intriguing watching most of them going against the TSX movements on a regular basis. You know you have a healthy portfolio when all your securities are weakly correlated with each other.
Although I’m not one to stereotype, somehow there’s a stigma and prejudice against income trusts as being no growth businesses that keep chugging steams of cash while draining down their assets. Since I’ve not analyzed every single trusts out there, I can’t confirm if the majority of trusts are indeed decaying businesses, nor would that stop me from investing in this space.
Being a (wannabie) value investor, I believe it’s safer to hold only a handful of high-caliber trusts than buying the entire spectrum, which may potentially include a number of ugly cousins. By high-caliber, I mean trusts that offer at a minimum, the one-two-three knockout punch: sustainable distribution, strong growth profile, and sound fundamentals.
Without further ado, let’s sharpen our process! Please visit Canadian MoneyCentral for financial summaries, but it’s imperative that you peek under the hood by visiting the individual trust’s website. Many of which have an “Investor Relation” link to hunt down financial reports and distribution histories. For this checklist, I’ll reference CML Healthcare Income Fund, which is a leading provider of laboratory testing services in Ontario and the largest private provider of medical imaging services in Canada. (By the way, since the TSX is a Healthcare challenged index, most Canadians should consider opening their arms for home grown Healthcare stocks/trusts like CML Healthcare.)
- Sustainable Cash-Flow - The trust must generate enough cash to cover both distributions and capital expenditures. This is one hallmark of sustainable trust distributions. If the internal cash flow doesn’t cover its distribution and capital expenditure obligations, the business must seek external funding (debts and share issuance) which is a major warning sign. Looking at their 2006 cash flow statement, the CML earned $98.4M cash from operations. In the process, they depreciated and depleted their assets by $3.28M. They have enough operational cash flow to cover both the $3.28M as well as the $78.81M distribution to shareholders without resorting to debts and share issuance.
- Strong Growth Profile - The trust must have a strong growth profile. We’re not looking for the “good enough” trusts. To quote my ex-Marketing Director:
We’re not in the business of pain-killing. We’re not the Tylenol; we’re the Viagra!
Just meeting the minimum cash flow requirement isn’t good enough. We want exceptional trusts that not only reward investors with reliable distributions and, but retain the excess to propel and grow the business well into our retirements. CML’s cash-flow didn’t merely meet the depreciation/depletion and distribution, they exceeded them. What are they doing with the extra cash? Their spent $10.9M on “Cash From Investing Activities”, which is more than enough to replenish the $3.28M depreciation/depletion. In addition, they paid back $1.12M in debts and retained $2.54M in the bank. I probably didn’t pick the best example
since CML’s distribution is relatively short(since 2004) but they had raisen their distribution twice. - Strong Fundamentals - The overall business must be sound. For instance, both the Profit Margin and Return On Capital should be higher than peers, and Debt/Equity should be manageable for the industry. There are always exceptions to the rule. For instance, it’s reasonable for REITs to have higher Debt/Equity ratios, because they can match long-term fixed mortgages with their long-term tenant contracts. CML’s Return on Capital and Net Profit Margin are 13.7% and 34.4% respectively, which are stellar for income trusts. Meanwhile, their 0.36 Debt/Equity ratio is much more conservative than the industry’s 1.39.
I have no doubt that there are gaps in my analysis. Consider this draft one. If I receive enough feedbacks, I’ll post version 2 of the checklist.
Really good post.
I think you are aware of my Income Trust strategy that I am employing for my wife’s mat. leave. I think I am going to use IPL.UN and CWI.UN for this. What are your thoughts on the distirubtion safety and capital stability of these two?