Invest Skeptically

This is my first blog entry and I thought I’d be a good Canadian and talk about income trusts. I came across this great summary of what trusts are all about and the necessary cautions about how they were — and are — marketed (Warning: there are many broken links on that site).

For those not yet up to speed the basic idea publicized by smart people like Al Rosen is this: trusts were marketed for their “yield” and compared to bonds. However, income trusts represent equity — not debt (bonds)! Also, the “yield” being marketed was actually a combination of a return on capital and return of capital.

More caution is required here.

Some Canadian tax basics: The return on capital (or interest) is taxable at your normal tax rate which is higher than what you would pay for a corporate dividend payout. Also, the return of capital reduces your average cost base which increases your capital gains tax payable when you eventually sell your trust units.

You may be wondering where the return of capital comes from. Basically it represents the amount that the business paid out in distributions that was in excess of its taxable earnings. Another way to think of it is getting paid part of your money back. The concern here is that the cash came from issuing more units (and diluting the value of your units in the process) and using that new cash to pay out distributions. Sound like a Ponzi scheme?

Despite all of these issues, investors were sold on the product and underwriting became more and more aggressive. How aggressive? Take the case of FMF Capital, a subprime lender based in Southfield, Michigan, that was brought to the Canadian market as an income trust on March 24, 2005 at an IPO price of $10. It traded down but on October 7, 2005 Nesbitt Burns (one of the underwriters) analysts issued an “outperform” rating with a target price of $9. By December 12, 2005 the stock price was down to $0.73. Eventually the stock was delisted from the TSX exchange and the company has subsequently announced an orderly wind-down of its business. Going public and then heading swiftly out of business is not how these IPOs should work.

On a related digression, I wonder if the Canadian government’s tax changes caused a secret sigh of relief among some of the more ethically-oriented investment bankers. The market was too hot and needed something to take the wind out of its sails (how’s that for a mixed metaphor?).

To conclude with some lessons learned: (1) understand where you are on the capital structure (i.e. debt vs equity); (2) look past all the bells and whistles of “structuring”, or “financial engineering”, and understand what it is you’re buying (e.g. do you like the underlying business?); (3) don’t let the high “yield” of a stock make you lose sight of the normal things you should be checking for (e.g. like earnings).