Financial Jungle

I’m collaborating with Thicken My Wallet and Million Dollar Journey to compose a series of posts on income trusts investing. Thicken My Wallet is leading the series with a bird-eye’s view on the financials such as payout ratios, cash-flows, capital expenditures and financing. I recommend you visit his introductory post, and then follow his links to the different categorizations of income trusts by Million Dollar Journey and me.

The traditional sense of business trusts is slow-growing mature businesses in the manufacturing, service or general industrial sectors. They typically produce stable cash-flow and distributions to trust-holders, which is why yield-starving investors are finding the distributions from business trusts irresistibly tempting. However, critics are warning that a majority of business trusts are sprinkling only small amounts of genuine income from operations, while a significant amount (over a third) of the distributions are simply return of equity.

Return of equity is the original capital returned to investors. For instance, suppose you invest $10 in my business. When I take $1 out of the pool and give it back to you, that’s a return of capital. You get your dollar back, but your investment is now worth only $9. Obviously, this magic show can only sustain until there’re no more rabbits in the hat. It’s crucial for investors to scrutinize the distributions beyond the yield percentage. Often, a trust yielding 6% has fortified growth profile and solvency, but another is upholding its 15% yield using cash from new share issuances. Some people call this scheme Ponzi, where the business tallies up cash from new investors to maintain the distribution.

Here at Financial Jungle, we shun away from return of capitals, and favour only exceptional business trusts that produce sufficient cash-flow to fund all of maintenance expenses, income distributions and growth. One such fabulous trust is North West Company fund (NWF.un), which constantly brings me tears of joy whenever I admire its filthy rich cash flow statement. Here are some criteria I’m looking for:

• Cash from Operating Activities - This is a summation of all the cash generated from the business’ operations. Although an up trend is a must, investors must ascertain the quality of the operational cash-flow to rule out any anomalies within. For examples, is the trust producing a humongous cash-flow by deferring tax obligations and/or not replenishing working capital? Investing Skeptically lead me to this article by the ferocious Al Rosen. In his words,
  
  

  We tell our institutional money-managing clients that all cash flow mistakes result from the arbitrary timing or classification of management actions or inactions.

  I believe one method of rectifing the disparity of timing is to measure the trend over multiple fiscal years instead of snapshotting one year. Looking at North West Company fund, the operational cash flow looks reasonably clean: income is rising, depreciation is stable, and working capital evens out over time.

• Cash from Investing Activities - The crucial factor is capital expenditures. Capital expenditures are investments made by the trust to maintain or grow the operations through purchases of physical assets such as property, industrial buildings or equipment. Trusts with capital expenditures greater than depreciation indicates that they’re replacing depleted assets as well as increasing capacity to stimulate operation growth.
  
  

  North West Company fund depreciated their assets by $120 mil over the previous 5 years. During this time, they reinvested $130 mil back to the business.

• Cash from Financing Activities - Total Cash Dividends Paid is arguably the most cherished figure by income investors; this is the actual cash distributed to trust holders. Any high-caliber business trust will fund this distribution internally with surpluses from operation after replacing depreciation.
  
  

  For instance, North West Company fund has $81.49 mil from operational cash-flow in 2006. Depreciation is $26.17 mil. That results in a surplus of $55.32 mil, which is more than enough to satisfy the $38.7 mil distribution. In fact, the trust has enough cash left over to expand its stores (capital expenditures > depreciation), buy back some shares (retirement of stock by $1.53 mil ), and repay some debts (retirement of debt by $5.57 mil).

Needless to say, I’m giving North West Company’s cash-flow statement a clean bill of health. I’d love to know what you think of this post, and learn your unique angles on business trusts investing. What other criteria do you fancy in business trusts?

Examples of business trusts

• Restaurants - A&W Royalties (8.7%), Boston Pizza (9.2%) and The Keg (8.8%)
• Transportation - Transforce Income (11.0%) and Contrans Income (11.0%)
• Retails - North West Company (5.6%) and Sleep Country (5.9%)
• Health Care - CML Healthcare (6.5%)
• Specialities - Versacold Income (8.2%), SFK Pulp Fund (11.8%)
• Media and Telecommunication - Yellow Pages Income (7.6%) and Bell Aliant (8.8%)