Trusts still offer upside potential: GGOF

By Mark Noble | May 7, 2007 | Last updated on May 7, 2007
3 min read

Last fall’s tax changes on income trusts may have been a blessing in disguise, separating the weak investments from the strong, according to Guardian Group of Funds executives, who believe that successful companies will prevail in spite of the new tax regime.

Guardian Capital’s Michelle Robitaille, a portfolio manager of GGOF’s Monthly High Income Fund, says in some ways the tax changes have highlighted the companies that will be able to deliver payouts in spite of the tax, versus those that simply adopted the trust model to capitalize on a lower -tax rate.

“A lot of the high-quality trusts were formerly high- quality corporations,” Robitaille says. “Good trusts are structured that way because it works for their business model. High- quality trusts [continue to] have high payout levels.”

Still, GGOF admits the tax changes were devastating. Having now accounted for those losses, they it believes that quality trusts are a worthwhile investment, even when you factor in the looming 31.5% tax they will be subject to in 2011.

Up until Jim Flaherty’s Halloween announcement last year, the income trust market in Canada had grown from $15 billion to $200 billion, but since then, momentum has been lost. John Priestman, managing director at Guardian Capital, believes trusts still have growth potential because of increasing demand for income yield, particularly from boomers as they enter retirement.

“They trade at about the same valuation as common stock but they provide much better pre-tax and after- tax -yield,” Priestman says. “Even since the Halloween surprise, trusts have performed surprisingly well. Since November 2, GGOF’s two monthly high- income funds have produced a total return of 16.5% to the end of the April 30. The year -to -date return is around 8%.”

GGOF points out that the yield on the S&P/TSX Income Trust Index has been around 9%, which is substantially higher than the 1.7% yield of the S&P/TSX Composite Index.

Both Robitaille and Priestman say successful income trust investing is based on following the fundamentals of investing in a well-run company. Priestman notes that their income funds only look at only about 75 trusts in the marketplace and at any given time, they only have about 25 to 40 names in their portfolio. He thinks their investment strategy is reinforced by the fact that many of the high- quality trusts they look at are also being aggressively pursued by private equity firms, which also recognize their value potential.

Brent Fullard, the Ontario-based president and founder of the Canadian Association of Income Trust Investors, takes exception with to some of GGOF’s logic. While he agrees that high-quality trusts are often well-run companies, he notes that average public investors will not be able to benefit from them because they are private- take-over targets. The tax changes, which led to trust devaluation, will not affect private equity because they won’t be subject to the new tax regime.

“The very thing that makes for a good trust is a stable secure business that throws out a lot of cash and has some growth. That’s exactly the parameters that private equity is scouring the world looking for,” Fullard says. “What do these private equity companies contribute towards our economy? Nothing.”

Fullard also points out that investing in income trusts now doesn’t address the $35 billion in losses that investors have incurred and not been able to recover. He says the tax kills their future since most trust investors are interested in the income rather than the growth of the company, and the tax drastically reduces that income by a third.

“There’s no scenario where this works out. If your house had a 31.5% tax that was going to be imposed within four years, do you think it would ever recover from that? It’s inconceivable; it’s lost too much value.”

However, GGOF believes that a lot of money can be made in those four years if trusts continue to grow at their current pace. Priestman even suggests that investors can afford to gamble on a change in government. He says the Conservatives’ dismissal or a reversal in their policy would send trust values skyrocketing, while all of the downside risks with trusts are already priced in.

“In a sense, there is a pretty good risk/reward ratio on income trusts. All of the bad news has been discounted, but we are not paying for any upside in changes that may be forthcoming over the next four years,” he says.

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Mark Noble