Financial Jungle

As any dividend investor will attest to, the regimen of successful dividend investing involves building a watch list of terrific companies with a long history of rising dividends, but only buy when they are cheap. How do you know when they’re cheap? There is a number of matrices out there at your disposal, but the 2 simplest are:

• Buy when P/E is trading near the historical low.
• Buy when yield is trading near the historical high.

If you’re like me, you’ll find it daunting to decipher the historical dividend payments and earnings to arrive at the highs, lows and averages. Fear no more. There is an excellent little tool that you must throw into your bag of tricks. It’s called, BigCharts. Not only does BigCharts show off the dividend growth of your favourite dividend stocks, it presents the rolling dividends, rolling earnings, historical P/E ratio and historical yield in neat little charts. Forget tables. They’re too discrete. Aspired dividend investors will want historical yield presented in a continuous graph in order to experience or feel the personality of the stocks over a long period of time.

Let’s take an example. Judging from Royal Bank’s historical yield, it’s currently trading at an attractive level yielding a historical high, 3.5%. Simply by gliding BigCharts’ cursor along the 10-year historical yield chart, you can quickly reckon and appreciate the rare but brief moments when Royal Bank traded near this seemingly tantalizing level over the past decade. If history repeats itself, the bargain price won’t remain on the table for long, and probably won’t return for several years. For full disclosure, I bought a bunch of Royal Bank shares yesterday.

One quibble I have with BigCharts is its fragile runtime on Internet Explorer; the Java applet crashes whenever I enter a Canadian stock symbol. It seems to work better on FireFox, so I downloaded a copy just to run BigCharts. Don’t forget to prefix “ca:” in front of your Canadian stock symbols. i.e. “ca:ry”.

Another thing to watch out for is that BigCharts uses trailing 12-months but my preference is forward yield. Nevertheless, the method used is irrelevant as long as it’s consistent. Royal Bank’s forward yield is 3.81%.

Please check it out and let me know what you think. If you have an even better tool, please share.

I wrote this list back in early April when Financial Jungle was relatively unknown. With readership growing, I decided to resurrect and update my top reasons to invest in dividend paying stocks.

1. Dividends set a floor price – Dividend stocks tend to trade within their yield range, and rarely do they yield much higher than Treasury bill. Last summer I purchased Bank of Montreal at $60.50 when it was yielding near the historical high of 4.1%. Not only did the yield defend the stock at this price point, BMO also distributed $3.25 worth of dividends since my purchase, and increased their dividends 4 times.
2. Dividends account for over half of the long-term real return – If you own 100 shares of BMO and receive 4% of dividends, you can DRIP your dividends to buy another 4 more shares. If you keep up the DRIP for 20 years, you’ll have a handsome 219 BMO shares in your portfolio. Even better, some Canadian corporations offer 5% discounts through DRIP.
3. Companies with long-term track records of stable and raising dividends show quality of the managements – Managements show commitment to shareholders by improving fundamentals and sharing profits.
4. Dividends cannot be manipulated like earnings – Dividends are real hard cash in your lap. Earnings can be faked by creative accounting.
5. A stable stream of dividends reward investors even during market down turn – Management pays you to wait even during market setbacks.
6. Dividends are more tax efficient than regular incomes and capital gains – In British Columbia, if you can make $66,000 in dividends, you pay $0 tax. In regular incomes, you pay $16,880 in taxes. In capital gains, you pay $5,097.
7. You can safely spend your dividends without harming your portfolio – If you think in terms of income streams instead of portfolio size, you can consume 100% of your dividends without hurting your portfolio. If instead you go for capital gains, consuming your capital during a depressed market will harm your portfolio immensely.
8. Receiving dividends are passive – Dividends and increases are given to you each quarter automatically without any action on your part. On the other hand, to receive capital gains, you must monitor the share prices continuously.
9. High dividend paying stocks have historically out-performed low-yield stocks – In David Dreman’s Forbes column (April 2004), he cited that between 1970 and 2003, the top fifth highest yield stocks returned 14.5%, while the lowest fifth returned only 8.8%.
10. Dividends are more predictable than capital gains – Suppose BMO averages 10% over the long term with 4% in dividends and 6% in capital gains. In a given year, you can count on seeing the 4% in your brokerage account, but the 6% capital gain is less dependable.

Bonus reasons:

• Your investment return depends on the company’s fundamentals, not the market’s temperament- You may think a business is wonderful and its stock is outrageously undervalued, but if market doesn’t share your excitement, your effort won’t bring you fruition, and you’re needlessly squandering away precious time. On the other hand, if dividends and dividend increases are your investment objectives, you don’t need the market’s blessing to celebrate. This is one fundamental advantage of dividend investing. When you buy dividend-paying stocks, there’s a strong linkage between your analysis and your reward, and this linkage isn’t compromised by market psychology.
• Dividend investing forces you to think in a healthy frame of mind in terms of buying low - I bought IGM last year. I bought it again this year. I will buy it next year, and possibly for the next 20 years. Why would I want my initial purchase to rise at the expense of penalizing my next 20 purchases? The next time you see dividend-paying stocks tumbling down, please come and give me a high-five.

The market tormenting me. The extra turbulence over the last few business days had taken everyone prisoner, except that they allowed the Biovail stock to revive 10% from its 52-weeks low. D’oh! I was so close in securing a juicy 10% dividend yield, my Achilles’ heel in investing, but the stock got away from me, at least for now.

Immediatelly after FDA’s thumbs down on Biovail’s studies on its formulation of bupropion, “a key component of a new antidepressant”, the market punished Biovail mercilessly sending the stock 37% lower to $17. In the process, it lifted the yield to a remarkable 8.8%.

This drug was supposed to fill the revenue hole left by Wellburtrin XL, a time-release antidepressant which accounted for 44% of Biovail’s revenues. Wellburtrin XL comes in 2 versions: the 300- and 150-milligram dosage. The 300-milligram version is already off-patent, while the 150-milligram version will face copy-cat competitions from generic producers. According to Biovail’s second-quarter financial report, generic competitions had swallowed half of the Wellburtrin XL revenues. That’s a 20% decline of total revenues.

Is the correction overdone? I think so. At the very least, I believe the stock has absorbed much of the decline and there’s plenty of value left in the post-Wellburtrin era. I know this isn’t a growth story like my superstar generic, TEVA. But, if the stock is indeed sufficiently below its intrinsic value, who will say no to free money?

Where’re the values? For starters, the company has $870 million in the bank in 2007 Q1. It means when you buy Biovail for $18/share, $5.40 is cash in the bank, so you’re really paying less than $13 for the pharmaceutical business. With the market being so volatile these days, patient investors might snap this up for a couple bucks less. Imagine one third of each Biovail share being backed by hard cash! I’d be stunned if the stock falls to anywhere near the vicinity of $5. Even cash flush stocks like Microsoft has only $2.49 on a $28.26 share.

The question that most critics enjoy picking on is can Biovail sustain the $1.50 dividend distribution policy in light of their top seller, Wellbutrin XL, going off-patent. For the sake of argument, let’s assume the misery by eliminating all revenues from Wellbutrin XL. (In real life, Wellbutrin XL should chug along residual revenues as with their other legacy drugs.) This drug is responsible for 44% of the 2006 revenues. Just to be on the conservative side, I’ll half their 2006 operational cash flow from $522 million to $261 million. Subtract $45 million for CapEx and $160 million for dividends, and that leaves $56 million of free cash, which serves as another margin of safety in my valuation.

Based on that, Biovail should sustain their dividend policy, but please help correct any flaws in my rudimentary analysis.

Possible Upsides:

• FDA’s eventual approval of bupropion.
• Successful foray into the multi-billion-dollar, global sexual-dysfunction market.
• According to their 2006 report, they have 10 new drugs in their product pipelines: 5 for central nervous system disorders, 2 for pain management, 2 for cardiovascular disease, and 1 for gastrointestinal disease.

One Objection I Heard:

Biovail relies heavily on outside collaboration/alliances with other companies, research institutes and projects for current R&D. Not having expertise in house can provide limitations over control.

Even with an army of in-house Ph.D.’s, expertise can be surprisingly difficult to find, according to a report by McKinsey Quarterly, Do You Know Where Your Experts Are - Companies need a new approach to finding their ellusive experts.

Early in the project, it needed someone with deep technical knowledge of a particular protein. We spent weeks looking for an expert — calling HR, asking around the office, scanning personnel records. Finally, we concluded the expert didn’t exist. Three days later, I’m in an elevator complaining about this to a colleague, when the woman next to me turns and says, “I wrote my doctoral thesis on that protein. What do you need to know?”

Take Procter & Gamble for example. Despite having a $1.7 billion R&D budget and 1,200 Ph.D.’s in-house, the company enjoyed a 45% success rate by outsourcing its most challenging problems to Innocentive, a market place setup by Eli Lilly to bring together solution seekers and 80,000 scientists from across the globe. I don’t view having a small R&D team as necessary a handicap for Biovail. In fact, it’s good risk management to selectively align with drug-development companies to license, develop, manufacture and market promising drugs to the market.

As always, I’m not your financial advisor. I’d be interested if anyone can point out any pitfalls with Biovail.

Disclosure: I don’t own Biovail shares, although I might start nibbling below $17.

In many ways, I’m living the deja vu of the 2006 summer correction. The skittish stock market, beleaguered by the subprime mortgage woes and the credit crunch, is lunging 1% ahead one day and plummeting 2% the next. As in the last summer, my Hotmail account is flooded with stock alerts which I setup on Globe Investors. Not that I’m pulling the trigger on every alert. It’s more for awareness than anything else, however I did nibble on few fallen stars like as Bank of America, Citigroup, Bank of Nova Scotia, Bank of Montreal, National Bank, CI Financial, Telus and Talisman, and 2 significant positions on Inter Pipeline fund and Boston Pizza Royalty fund.

It’s nerve racking to watch some of my holdings tumble, but I’m thrilled at the same time as I need to deploy new savings to high-quality but inexpensive businesses, and most stock screens always seem to bring me back to the same stocks in my portfolio. If I have it my way, we’d have a correction every second day, and Bank of Montreal would remain at $61 for the rest of my life, because a cheaper stock means more shares, more dividends and more importantly, a shorter road to financial freedom. I bought BMO in 2006 at $60.40. It rocketed to $72 before falling back to my purchase price momentarily on Wednesday. Fantastic! Same price as last year, but with a phenomenal 4.4% yield that will knock your socks off - they increased their dividends by 28%. It’s not just BMO, the other Canadian banks are teasing me with their dividends too.

If I learned anything from the 2006 correction, it’s that the moody market rewards contrarian dividend investors who have the conviction to become net buyers in a tough market. Looking back, I’m laughing myself silly that I peed my pants (not literally) when I bought IGM below $45 at a time when other investors were cringing under the falling sky. No, I wasn’t a genius. I was simply good at following instruction out of any sensible dividend investing book such as “Stop Working” by Derek Foster. Since that time, IGM’s quarterly dividends surged from 37 cents to 46 cents per share — a 24% hike! I need to have a talk with my boss about matching that pay raise.

Alas, I’m still a rookie investor. Some of my purchases have been premature; most notably DR. Horton. This time, I suspect it’ll take longer than a year before l laugh myself silly. Although my batting average is far from perfect, over the long-term, I feel that the aggregate of all the dividend-paying positions will do marvelously. Aspiring dividend investors who hang tough in this ordeal won’t come out empty handed, especially when corporate balance sheets are strong, profits are rich and unemployement rate is at a 33-year low.

In order to elevate fundamentals over the long-run, short-term pains are necessary to prune out dead weights, such as questionable structured commercial papers, loose lending standards and as ThickenMyWallet put it, NINJAs (no income, no job, no asset). Once these excess baggages are out of the way, the path to prosperity is paved for many decades to come.

Jungle Guy’s shopping list: all Canadian banks, REITs, Yellow Pages, Reitmans, pipelines (TRP/ ENB/IPL.un), insurance (MFC/SLF), CML Healthcare and CI Financial.

I’ve failed over and over and over again in my life and that is why I succeed.

Michael Jordan says it well. Shouldn’t we celebrate and honour our failures as if they’re stars on our shoulders? Even the best basketball player in the world couldn’t make a cut for his high school basketball team, so why should we expect perfection in investing? In fact, the stock market is a place that rewards players who expect failures, because they understand the law of taking a step back and springing two steps forward.

I have this odd habit of observing how investors with different experiences interact in the forums. One consistency and irony I find is that seasoned investors tend to reveal their mistakes more openly, while know-it-all amateurs tend to be more egotistic. Perhaps it’s simply human nature to seek social acceptance by putting their best foot forward — even when neither feet is modeling material. On the other hand, mature investors see every failure as an opportunity to turn over a new leaf. By regularly acknowledging mistakes, these investors become receptive to constructive criticisms from themselves and others, and leave the door opened for further touch-ups to their investment philosophies.

“Sometimes it is better to lose and do the right thing than to win and do the wrong thing.”- Tony Blair

Now that they have inspired me, I’ll reveal my wall of shame!

DoubleClick - Bought $91, sold $76 one month later.
Cisco - Bought $104, sold $73 nine months later.
Knight/Trimark - Bought $57, sold $35 four months later.
AboveNet - Bought $55, sold $39 two months later.

The worst blunders?

Conexant Systems - Bought $163. Still holding it at $1.36.
AirIQ - Bought $28. Still holding it at $0.15.

The lessons I learned? Always invest for the long-term, analyze the financial statements and think independently from the others — but it’s okay compare notes with experienced investors whom you respect.

ps. If you don’t have a role model, I recommend you frequent the Financial Webrings investment forum.

ps2. I have more blunders, but can’t find all the receipts at the moment.

I’ve recently picked up a couple of non-financial income trusts: Inter Pipeline and Boston Pizza Royalty Income Fund.

Inter Pipeline Fund

You can read about Inter Pipeline in my How To Pick Pipeline Trusts post, where I highlighted their key assets as well as their strong and growing free cash flow. Interestingly, The Vancouver Sun has an article on Not enough pipeline for surging oil production, regular says.

The National Energy Board said the pipeline industry may face a capacity crunch as oil output this year rises to 2.9 million barrels a day, nine per cent more than in 2006. Almost all new Canadian oil comes from the oilsands region of northern Alberta, where more than $100 billion worth of projects to exploit reserves are planned or underway.

Boston Pizza Royalty Income Fund

Onto Boston Pizza Royalty Income Fund, this is my very first restaurant investment. The fund owns the Boston Pizza trademarks and licenses them to a private corporation, Boston Pizza International (BPI), for a 99-year term. In return, BPI compensates the fund with 4% of franchise revenues from 266 Boston Pizza restaurants across Canada. The beauty of this “top-line” funneling is that the fund enjoys a stable and consistent cash flow with no dependency on the restaurants’ profitability. Their cash flow statements are an eye-opener — no capital expenditures! BPI and their franchisees incur all the maintenance and expansion costs, while the fund gleans 4% off their total sales.

There are few contenders in the restaurant royalty space, which includes A&W Revenues Royalties, Pizza Pizza and The Keg Royalties Income Fund. However, Boston Pizza Royalty stands out of the pack with their higher liquidity (about 4x the others), generous yield (9.5%) and best-in-class same-store-sales-growth (6.5% over 10 years).

Same-store-sales-growth (SSSG) is crucial because that’s the main driver behind the fund’s distribution increases. The fund went public in 2002 with an initial monthly distribution of $0.0833, but has since risen it 12 times to $0.1130 for an annualized 6.36%, which is in line with the 6.5% SSSG.

Between the 9.5% yield and 6.36% growth, my expected internal rate of return is 15+%. The trust is trading at around $14.50 while distributing $0.113 per unit per month. This is a much better value than when it was trading at over $20 before Halloween. Back then, it was distributing only $0.109 per unit per month.

The distribution is about 84% taxable, so it’s more tax-efficient to hold the fund inside RRSP. Short of that, the second best option is to hold it under the spouse with the lower tax-bracket.

Reference:

• Boston Pizza Royalties Income Fund Fact Sheet
• Frequently asked questions

This MSN Money article by Jack Hough of SmartMoney is a must read if you’re a renter. I love this article for a number of reasons; it’s provocative, but more importantly, it’s like seeing myself in the mirror, since we share so many similar opinions together!

It’s not easy being a renter. Letting the world knows you’re a renter is like walking around town with a prominent “L” on your forehead. It’s just human nature. Renters are stereotyped as financially irresponsible people, however that’s simply a myopic view. There are just as many irresponsible buyers who live beyond their means by borrowing high-ratio mortgages. I don’t see homeownership as a necessity. Rather, it’s a culture, and sometimes, it’s even a status symbol like owning a BMW. No offense to Beamer owners.

Jack Hough starts his article with a confession that he rents despite having enough to buy a house. The reason? Stocks returned 7% inflation-adjusted over the previous century, while …

the average real return for houses over long periods might surprise you: It’s virtually zero.

Surely, that has to be a mistake! In the midst of one of the most glorious housing booms in Vancouver, homeowners roll their eyes when all the evidence point to double-digits return. Let’s not forget that over this short period (yes, 5 years is short), anything goes, but they don’t call it average for nothing. Sometimes prices overshoot, but eventually they’ll revert to the mean.

Over the long haul, home prices rise in tandem with rents. When prices race ahead of rents, the equilibrium is disrupted temporary until either (a) prices fall or (b) prices plateau in order for rents to catch up. In the case of Vancouver, rents haven’t gone up as much, so price appreciation comes mostly from valuation expansion. To steal an analogy from the stock market, a stock can trend higher via P/E expansion even with earnings remain flat, but P/E expansions aren’t sustainable. Only fundamental improvements like earnings growth can push the share price higher over the long term. To give you some perspective, we sold our home in Nov 2006. The earning yield (which I inflated to satisfy any nit picky readers) was 3.9%. It was 5.2% when we bought 3 year earlier, and 7% when our former neighbors bought theirs.

Make no mistake about it. Renting and investing the difference in the stock market isn’t for the faint at heart. If you don’t have the stomach to face recurring setbacks in your portfolios, the little butterflies in you will hinder the execution. This post aren’t to encourage readers to sell their homes, but to point out that diverse point-of-views exist and they’re just as rational.

In his article, Jack Hough tackled a few common objections to this approach:

“You can’t live in your stocks” or “Renters throw money down the drain.”
No, but with a combination of diversified income trusts (read my income trust series) and dividend yielding stocks, it’s possible to derive close to a 3.9% yield to cover most of my rents. Moreover, yields from dividend-paying stocks and growth-oriented income trusts will outpace inflation, while rents will move in tandem with inflation.

“What about the pride of homeownership?”
Pride of homeownership is overrated to me, though I admit it’s a matter of preference. Similar to Jack, I relish the pride of owning successful businesses. When I have the urge, I munch at my favourite Korean food court to admire the Telus building across the street. On a good bicep day, Scotia Bank is also only a stone’s throw away from my office.

Another one that I heard, “income trusts and dividend-paying stocks aren’t diversified”
That’s true to a degree, but it’s still considerably more diversified than a home. The leaky condos fiasco in the late 90’s serves as a reminder to complacent homeowners that a single misstep can send anyone to bankruptcy. Contrast that to REITs where with a few mouse clicks, your portfolio is instantly diversified across the nation and different real estate segments including residential, office, retail, hotel, industrial, storage and nursing homes.

Alright. Maybe I can fit a little sequel to the income trust series.

I’m not sure if anyone noticed, but there is a distinct divergence between prosperous and crummy trusts in the aftermath of the income trust tax ruling. The prosperous ones continued to flourish, while the crummy ones never quite recovered to their roaring days.

You heard of the old saying:

A rising tide lift all boats

As long as everyone was happy about receiving their 10+% yield, no one was questioning the sustainability of the underlying foundations that supported these yields. Alas, all good things must come to an end. The tide came and went. The Halloween upheaval exposed so many little elusive holes beneath some of the rottenest boats. The tax ruling announcement turned investors’ stomachs, and sure enough, most trusts retreated 15-20% the next morning.

As painful as it may be, I think Ottawa’s decision to plug the tax leakage was a blessing in disguise as it forced out the excess speculation in the trust market. Even the most relentless critics must admit; investors today (including myself) are more attentive to the quality of trusts. This is good! It serves as a wake-up call. Fussy unitholders put their trusts in a spotlight and make management more accountable to their actions. Wouldn’t you rather suffer a healthy 20% haircut today, than having your 10% yield tab shut tight during your golden years?

What do I mean by prosperous and crummy trusts? To illustrate, let’s contrast 2 strikingly different trusts: Canadian Oil Sand and Vault Energy Trust .

Now scrutinize Vault Energy 2006 cash flow statement and balance sheet. Folks, this is a textbook income trust that forensic accountant, Al Rosen, would love to hate!

• The $45.61 mil cash flow from operations is too cute when standing next to the $88 mil from capital expenditures and cash distribution.
• Switching over to their balance sheet, total assets are falling, total liabilities are rising, thus book value is falling.
• Outstanding shares are rising, which further dilutes the existing shares.

Still think all trusts are created equal?

One great reward about being a blogger is the new insights you gain from researching and presenting articles. It’s one thing to skim over the Internet for the lowdown of income trusts, but quite another to articulate them to an audience. So much to learn still despite spending a couple of evenings on O&G trusts. Well, this post wraps up my part on the income trusts series initiated by Thicken My Wallet. I hope you’re enjoying it so far.

Saving the worst for last, oil and gas trusts are probably the most provocative group of all.

O&G trusts are holding structures that own the right to royalties on the production of natural reserves. These trusts do not engage in explorations. Instead, they negotiate and buy royalties from exploration companies. These exploration companies will generally stay behind to manage the production, but the trusts and their unitholders own the right to the stream of profits from the reserves. The one key difference between investing in O&G trusts and most other investments is that at the end of the day, your equity vanishes! Poof! Your objective is to squeeze every drop of your money back from the reserves, and hopefully a little more to compensate you for the risk-taking.

On the surface, O&G trusts have few bright spots:

• No exploration risks
• Reserves are well known
• Productions are well known
• Operation costs are well known

Alas, these trusts also come with a number of caveats; one being the limited lifespan of these reserves, many of which will not survive more than 10 years. In order to nourish the cash distributions to unitholders, the trusts must continuously replenish depleting reserves through new acquisitions. Huh? New acquisitions? Where are the down payments coming from? Through share issuances and debt financing of course. This part bugs me the most. This arrangement is reminiscent of the Ponzi scheme, where money from new investors is scrounged to maintain distributions to existing unitholders. The tale doesn’t end here, because the new reserves, as their predecessors, also have a limited lifespan. Saving investors from the agony of waning income, the trusts must dig themselves into deeper holes by tallying up even more investors and even more money to fund even more new reserves.

This illustrates the fundamental flaws of this trust model. No rational investor will want to share her profits when she’s the one risking her money on the line. If she’s the rightful owner of the new oil wells, she deserves all the cash flow produced from it.

Our anxieties shouldn’t end here. In addition to the dwindling reserves, investors must be conscious of future oil and gas prices. For instance, the price of crude oil today is $75 which is near its historical high. If the production cost per barrel of oil is $45, one may project a margin of $30 per barrel until all the reserves are depleted, but this is not a sure thing. A mere $10 drop per barrel would evaporate 33% of the profits. Even a cursory understanding of the intricacies behind oil and gas trusts explains why cash flows from O&G trusts can be erratic over time when compared to bonds. Oil trusts achieve high levels of operating leverage as their production costs are largely fixed no matter what the crude oil price is. Profits are a function of the prevailing crude oil price. As oil price diverges from costs, profits expand. Conversely, as oil price gravitates toward costs, profits erode. The lowest cost producers have the best competitive advantage against price volatility.

Finally, O&G trusts are very interest rate sensitive, as with all income trusts. This is a given.

With these caveats in mind, I’ve compiled the following criteria to help jump start your search if you’re extremely bullish on energy prices.

• Long-life reserves - Keep the distributions coming longer.
• Low(est) cost producer - Profits from the lowest cost producers are the least sensitive to energy prices. Likewise, a small dip in oil prices can wipe out all of profits from the least efficient producers.
• Clean balance sheet - The less debt on the balance sheet (low Debt/Equity ratio), the less sensitive it is to interest rate fluctuations.
• Low payout ratio - This is especially true for O&G trusts that engage in Pac-Man acquisition sprees.

Example: Canadian Oil Sand

If I were to invest in an oil trust, it’d probably be Canadian Oil Sand. It owns a 37% interest in the Syncrude project, a pure play in an oil sand that has stunning reserve life of 40+ years. I believe the slow depletion rate is confirmed by the miniscule 3% in of Return of Capital. The trust also sports a healthy 0.36 Debt/Equity ratio and 55% payout ratio, notwithstanding a weak 4.9% yield. Based on some preliminary readings on their web site and StockChase.com, they have just completed the third and final stage of their Syncrude 21 expansion. With capital spending behind them, analysts expect distributions to rise this and next year subject to oil price remaining at a high level.

According to Syncrude, their operating cost per barrel is $26.46 in 2006. That’s pretty cheap! Perhaps I’m missing something, but there is an enormous margin between the operating cost and the market price of $75 per barrel. The dual of low debt obligation and efficient production should yield some breathing room from external crisis such as deteriorating oil price and soaring interest rates.

Other Oil and Gas Trusts

• PenGrowth Energy
• EnerPlus Resource
• Bonavista Energy
• Crescent Point Energy
• Harvest Energy

Additional Resources

• In case you’re interested, a video of the oil sand production process is available here: “How We Make Oil at Syncrude”
• Hot idea fuelled energy trusts - A nice history on energy trusts.
• To keep abreast on the current energy prices, visit Bloomberg.

Pipeline trusts are terrific additions to any diversified portfolio; their cash flows are generous, predictable and sustainable. When you buy a pipeline trust, you’re buying a combination of long-lasting energy infrastructure cash-cow machines used to transport and store oil and gas. Many pipeline trusts are involved in some of the largest and longest-lasting oil projects in North America, thus enabling them to secure long-term contracts to transport oil from productions to refineries.

What are some of the key characteristics of pipeline trusts?

1. Strong competitive advantages from high barriers to new competitions due to hefty capital costs, government regulations and brands.
2. Pipelines have longevity and low maintenance.
3. Revenues are largely fixed while capital expenditures are minimal. (Translation: reliable cash flows)
4. Not much growth potential. Buying at the right price is crucial, because you don’t want to be stuck with a low yielding and slow growing investment.
5. Unlike oil and gas production trusts, pipeline trusts’ transportation revenues are generally decoupled from commodity prices.
6. Since pipeline trusts must compete with other income-based securities, share prices are sensitive to the prevailing interest rates.

What to look for in a pipeline trust?

• Squeaky-clean balance sheets - We want to turn away trusts burdened with massive debts on their balance sheets. Trusts with conservative capital structures desensitize themselves from rising interest rates, and give them little wiggle room to expand. The key ratio to look for is the Debt-to-Equity ratio. Here are several examples: Inter Pipeline (0.56), Pembina Pipeline (0.75) and Fort Chicago Energy Partners (1.99 - ouch!)
• Positive cash flow - As with all income trusts, ensure the pipeline business generates enough money to maintain existing infrastructures and to pay us cash distributions. Normally, I’d glance over the cash flow statement from MSN Finance, but there underlies a problem; capital expenditures lump both maintenance and expansions together. Since a few of the major pipeline trusts, likeInter Pipeline and Pembina Pipeline) are currently in expansion mode, I have to discern maintenance from other growth initiatives. Otherwise, MSN Finance will confuse me into thinking that these trusts are bolstering the distributions with new shares and debts — a very yucky situation. There are no short-cuts. Investors must download and soak up the annual reports to separate out the maintenance expenses.
• Payout ratios - This goes hand-in-hand with the positive cash flow criterion above. The lower the payout ratio, the safer the distributions. Do not blindly accept the payout ratios from third-party sources, such as MSN Finance, due to discrepancies in how distributable cash flows are calculated. It’s best to crunch the payout ratio yourself. An example is coming.
• High S&P Stability Rating - A trust with a high S&P stability rating has a better chance of sustaining the distribution. Most of the high quality individual trusts have an SR-2 rating, whereas “portfolios of funds” tend to have the SR-1 rating. Some of the SR-2 rated trusts include CML Healthcare, Pembina Pipeline, RioCan and Yellow Pages. It’s too bad that S&P doesn’t rate all the available trusts. However if a trust is listed and it’s below SR-2, don’t bother investing.

Example: Inter Pipeline

There are several popular pipeline trusts at your disposal, but I’ll pick Inter Pipeline since Money Gardener has been nagging me a couple of times. When you buy Inter Pipeline, you become part-owner of the following enduring assets:

• 5,900 kilometres long of petroleum pipelines (Four conventional oil pipelines, and two oil sand pipelines).
• 3.6 million barrels of storage in western Canada.
• The above assets pipe 822,000 barrels per day of oil sands bitumen, conventional crude oil and gas plant condensate, with a market share of 18% in western Canadian conventional volumes and 50% of oil sands volumes. These represent 44% of earnings.
• 3 major natural gas liquids extraction facilities in southern Alberta on the TransCanada system. These facilities are processing 4.2 billion cubic feet/day of natural gas and producing 142,100 barrels/day of natural gas liquids for now, but have the capacity to process 6.2 bcf/d of natural gas, and 195,000 b/d of natural gas liquids. (Don’t ask me what these numbers mean. ) These represent 41% of earnings.
• More impressively, their natural gas extraction facilities are responsible for processing 40% of Alberta’s natural gas export.
• 9 bulk liquid storage terminals in UK, Germany and Ireland. These represent 15% of earnings.

You can find Inter Pipeline’s distribution history here. As of this writing, the trust is trading at $9.51 with an 8.85% yield. The distribution is 85% taxable with remaining as tax-deferred capital gains (return of capital). Do keep in mine that although unitholders have been indulged with a bountiful yield, in exchange, they settled with an uninspiring 3.2% distribution growth rate.

Inter Pipeline has a positive cash flow. According to the cash flow statement, operational cash flow in 2006 is $201 mil. At first glance, this cash flow doesn’t cover the $160 mil cash distributions to unitholders and the $65 mil in capital expenditures, but wait. As I alluded to earlier, part of the capital expenditures is assigned to growth. According to page 40 of their 2006 annual report, only $5.6 mil was “sustaining capital expenditures”. The effective payout ratio after sustaining capital expenditures is around a healthy 82% ($160 / [$201-$5.6]).

Unfortunately, S&P doesn’t have a rating on Inter Pipeline.

Valuation wise, the best two times to buy Inter Pipeline were in 1999 when investors were flocking to growth oriented technology stocks, and in Nov 2006 when Finance Minister, Mr. Flarity, detonated the Halloween bomb on taxing income trusts. Moving forward, I don’t see any more corrections in the horizon unless Bank of Canada hints further hikes are lurking beyond Sep 2007. The units have settled in the range of $9.00 and $9.80 and trending upward. The trust is suited for RRSP, because the tax on distributions can be deferred inside in registered accounts.

Disclosure: I don’t hold Inter Pipeline nor any other pipeline trusts. As always, I’m an amateur investor. Do not buy or sell securities based solely on the information provided on this site.

Examples of other pipeline trusts:

• Inter Pipeline
• Pembina Pipeline
• Fort Chicago
• AltaGas Income
• Gaz Metro
• Keyera Facilities

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%)

I was quite skeptical when Horizon BetaPro released this leveraged ETF at the beginning of this year. It promises to double the TSX 60’s daily volatility before various fees. For instance, if the index is up 1%, the ETF rises 2%. Conversely, if the index is down 1%, the ETF dips 2% as well.

Despite Horizon’s emphasis on daily performance, I believe the ETF should emulate two-times the index’s long performance provided that (a) the short-term amplifications remain consistent, and (b) the volatility is tame.

On the surface, this strategy is more electrifying compared to the alternative of direct leveraging. Let’s assume you like to double your TSX 60 holding with borrowed money at 6% prime. If the index is up 10% over the next 12 months, then your return on investment is 14% (10% plus the 4% on the borrowed money after paying for interests). With BetaPro, your ROI is 20%. Sweet! Secondly, with borrowed money, you can lose more than your ante, if the index tanks by more than 50%. With BetaPro, you only lose what you invested.

However, here’s the problem: the arithmetic breaks apart in a volatile market. For instance, if your $100 index fund declines 20%, and recovers 30% the next day, the resulting balance is $104 ($100 x 80% x 130% = $104). Effectively, you’re up 4%. On the other hand, when your $100 in BetaPro declines 40% and recovers 60%, the resulting balance is $96 ($100 x 60% x 160%). You’re down 4%, not doubling the index’s return. There’s no free lunch!

Arguably, this could be the most vulnerable time to double your exposure to this index after nearly five-years of uninterrupted prosperity. Investors should thread carefully.

This ETF is only six-months old, but the short history looks promising so far. The MER is 1.15% on your invested capital, or 0.575% when you spread it across the exposure. Since I’m more of a buy-and-hold investor, I may consider this ETF as long as it has the potential to reach my investment goal in half the time. Having said that, I’ll patiently observe how the ETF behaves over a complete market cycle prior to jumping in with both feet.

Sources

• Inverse and Leverage ETFs - Larry MacDonald
• Horizon BetaPro Funds