By Andrew Willis & Rob Carrick
The Globe And Mail
Friday, June 27, 2003

Choosing trust units that promise the biggest income bang is a strategy that is bound to backfire, ANDREW WILLIS and ROB CARRICK write.

Investing in trusts means embracing a contradiction.

Trusts are bought for their yield, for the monthly income promised to unitholders. So doesn't it just make sense that the best trusts boast the highest yields?

Not at all. Focusing exclusively on yields, on units that promise the biggest income bang for an invested buck, is a strategy that's bound to backfire. The reality of today's market is trusts with the highest yields are the most likely to disappoint.

More often than not, soaring yields signal a business is stumbling, and a trust's all-important distributions are about to be cut. The income trust hall of shame is rapidly filling with companies that boasted sweet double-digit yields just before they took the axe to investors' income.

Legacy Hotels Real Estate Investment Trust led its peers with a 12.8-per-cent yield just two weeks ago. It dropped to the back of the pack by suspending distributions, as severe acute respiratory syndrome (SARS) and the weak economy kept guests away from its hotels.

Setbacks like this haven't stopped investors from reaching for yield, the experts say, by setting aside common sense to buy companies that hold out the promise of more income.

"Investor appetite for yield is at an all-time high, all sorts of studies have shown. You can see that in the popularity of high-yield funds, dividend funds and trusts," says Ben Cheng, a mutual fund manager who holds more than $1-billion in trusts at CI Fund Management. Yet veteran investors say yield is the last thing they look at when deciding which trusts are worth holding.

"The yield is your destination when you're looking at valuing a trust. The journey is more important, where you look at the quality of the business and its management," says Oscar Belaiche, a Goodman & Co. money manager who also has more than $1-billion tied up in trusts.

The mistake many investors make is treating trusts as a substitute for bonds in their portfolios, a source of extra income at a time when interest rates are at all-time lows.

"Investor due diligence usually stops at the cash yield now being offered by a trust," says Adrian Mastracci, at KCM Wealth Management Inc. in Vancouver. "Investors forget that trusts are really equity instruments, as opposed to fixed income securities. There is little fixed about them."

In fact, trusts are high-yield equities. The income they throw off, and the underlying price of their units, moves in step with the prospects of the underlying business. That means some trusts are bound to stumble, just like any other company. And some are likely to deliver on, or exceed, their promise of cash distributions to unitholders.

"There are good trusts and bad trusts, just like there are good and bad companies," Mr. Belaiche says. "Our fundamental thesis is we buy good businesses at a reasonable price. We do not buy marginal business because they seem cheap."

In general terms, power companies are considered the safest trusts. These utilities are the most likely to keep their distribution promise.

Energy trusts are at the other end of the spectrum, as the most likely to burn investors. In large part, that's a reflection of the trusts' enormous exposure to moves in commodity prices. The risks and rewards of business trusts rank in between the power and energy trusts.

To compensate investors for putting their money on the line, yields range from 6 per cent in the strongest business trusts to highs of 16 per cent for the riskiest ventures. Yields in the business trust sector average 11 per cent. Energy trusts are averaging 18-per-cent yields these days, with oil and gas trusts considered likely to cut distributions in the face of declining reserves or falling oil prices, or both, yielding more than 20 per cent.

Like many investments, trust yields should be looked at with a view that if it sounds too good to be true, it's probably not true.

Now, here's the good news. The income a trust kicks off gives it an enormous performance advantage over other equities.

"For most investors, the choice between owning a trust and a regular stock is like a golfer's choice between hitting from the ladies' tees, or the back golds that the pros use," says Ira Gluskin, who holds $200-million worth of trusts at money manager Gluskin Sheff + Associates Inc. "The 10-per-cent yield on a trust is like teeing off 130 yards up the hole."

Picking the best trusts boils down to picking out which businesses make money in good times and bad, says Leslie Lundquist, a money manager at Bissett & Co. in Calgary. "My first priority is establishing the ability of the underlying business to continue throwing off cash, over time."

Making this call often boils down to finding quality management, something that doesn't show up in quarterly reports or an initial public offering prospectus.

"Prospectus-level disclosure can be tough to decipher. A prospectus is good as far as it goes. It's all in line with GAAP [generally accepted accounting principles] and other standards. But it can't give a good picture of where the underlying business is going," Ms. Lundquist says.

"The challenge in an IPO is to figure out what management is not telling you, what they are glossing over," says Bradley Dunkley at Gluskin Sheff. "We quiz management on their prospects, the competitive barriers to entry in their business and the potential for organic growth, or growth through acquisitions."

There are tools to help investors do this work. Rating agencies Standard & Poor's Corp. and Dominion Bond Rating Service Ltd. both rank trusts on their ability to keep making distributions.

The ratings focus on seven key components of the trust, including asset quality, market position and financial flexibility. The agencies then assign a rating that speaks to a fund's ability to sustain its distributions. These ratings are on the agencies' Web sites, and are typically included in the trust's marketing material.

What other tools can an investor bring to bear on trusts? Here's a list of what the pros look for when they weigh buying a trust.

Are the manager's interests aligned with those of unitholders? This means compensation for management must offer an incentive for handing out cash in distributions, and keeping the business going in the long term, with the capital spending needed to maintain the unit price.

If management is only paid to increase distributions, there's a danger it will run down the company by not reinvesting.

Watch for trusts that reward performance that's not in the unitholder's best interest. Legacy REIT and several of the energy trusts have been faulted for paying acquisition fees to their managers, which may encourage deal making for its own sake.

Is management internal? As a rule, managers working with the trust are preferable to external managers. If the managers are at another company, investors should question who they are working for. "We're generally comfortable with corporate sponsors who are also large shareholders, such as Bell Canada or Abitibi," Mr. Belaiche says. He said these outside managers also hold enormous stakes in the trusts, which aligns their interests with those of outside investors.

If yield isn't the right number to look at, what is? Many money managers start checking out trusts by comparing their enterprise value to EBITDA -- earnings before interest, taxes, depreciation and amortization.

Ms. Lundquist says the enterprise value is typically eight to 10 times EBITDA. Above this ratio, a trust is getting expensive in investors' eyes.

What's the payout ratio? This measures the amount of cash handed out to unitholders as a percentage of the total amount of cash generated by a business. Investors want to see a number that's under 100 per cent, signifying that the managers have some margin of error for running the business, capital spending and maintaining distributions. Continued on page 2...

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.