IPO craze
may raise quality issues
Income
trusts are the hottest type of investment on the street. The National Post
recently reported that 90 per cent of initial public offerings on the Toronto
Stock Exchange (TSX) were for income trusts. They pay generous cash
distributions; offer some growth potential; and sometimes provide a nice tax
benefit. What’s not to like? I agree income trusts have a long future ahead of
them on Canadian markets, but be careful not to get lured into junk.
Effectively,
a public offering of shares occurs when a company sells its shares to the
public at a set price. The term “public offering” refers to the fact that the
shares are offered (i.e. sold) on a public stock exchange, such as the TSX.
An initial
public offering (IPO) is the same thing, but it represents the very first time
such shares are being offered to the public; hence the word “initial”. In other
words, a company whose shares are making their trading debut on, for instance,
the TSX has made an IPO.
Investors
ultimately try to “buy low, and sell high”. If you’re buying shares from an
IPO, you’re part of the “buy” side of a company’s “sell” transaction (i.e. the
IPO). Company insiders, who help determine the timing and price of an IPO,
presumably know a lot about the company because, well, they’re insiders – i.e.
they have information about the company that the investing public probably does
not know.
In general
that doesn’t sound like a winning proposition for the buyer over time since the
timing and price of the buy occur as a result of company insiders’ desire to
sell. An IPO isn’t always a bad investment; but it stands to reason that IPOs
are not great investments, as a group.
An income
trust is simply one type of legal structure within which a business may
“reside”. Most organizations with shares trading on a stock exchange are set up
as corporations. An income trust, as the name implies, is a trust – just like a
mutual fund or exchange-traded fund. For trading purposes, however, income
trusts are just like stocks.
It’s safe
to say that the main motivation for companies organizing as (or spinning off
assets into) a trust is to put as much after-tax cash flow into investors’
pockets as possible. Corporations can and do pay dividends, but the corporation
must first pay tax on its profits before being able to pay them out as
dividends to shareholders. Then, individual shareholders pay tax on a portion
of the dividends received.
Income
trusts, by design, are structured around more mature businesses with relatively
more consistent cash flow but less potential for future growth. This is the
case in general, but there are exceptions. For tax purposes, trusts are taxed
just like individuals but with an important basic distinction.
Trusts are
taxed on all income at Canada’s highest marginal tax rate (46.4 per cent in
Ontario). However, trusts can avoid tax if they flow out a sufficient amount of
income out to its unitholders (i.e. shareholders).
Some businesses,
like real estate and energy firms, benefit from special tax deductions. But
rather than simply deducting it from income within a corporation, a trust can
actually flow this tax benefit out to unitholders. The result is that a portion
of the cash distributed to unitholders is tax-deferred.
Businesses
which intend to pay out as much as possible to its owners will be able to do so
most tax efficiently via a trust structure.
The last
time income trusts were the hottest thing going (around 1996), they were
marketed much more aggressively. At that time, investors were given the
opportunity to pay for their income trust units in instalments. For instance,
if a unit was offered for $10; the investor could pay $5 now, and the other $5
in a year’s time. Problem was, by the time the second half was due, many trusts
had halved in value.
This more
recent boom in income trusts is nothing like 1996. The general stock market
this time around is very weak; whereas 1996 was a pretty positive environment
for stocks. Bay Street also learned from the instalment receipt craze of 1996;
offering no such options this time around.
With
accounting irregularities and corporate fraud, investors feel safer with
investments paying out cold hard cash. Also, ultra-low interest rates make
income trusts naturally attractive to those depending on their investments for
income.
Don’t
equate the market’s infatuation with income trust with the tech euphoria that
ruled the day just three years ago. However, there is one disturbing trend
underway in this sector. Corporations are converting to income trusts just to
see its share price rise. This makes no sense and is ludicrous according to
Bill Shaw, lead manager of the Mavrix Dividend & Income fund.
In a recent
conversation, Mr. Shaw reminded me what happened the last time this sector was
overheated. He said the sector contained roughly forty trusts. When income
trusts busted, eight disappeared. That’s a “mortality” rate of 20 per cent. – a
significant amount.
With the
proliferation of income trusts to flood the market over the past year, there
definitely is a quality issue in general. Many existing trusts are quality
issues. However, many are not and are not likely to survive the next time this
sector goes through a cleansing.
Next week,
we’ll delve a bit deeper into income trusts and my top picks for mutual funds
focusing on these trendy investments.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.