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November 18, 2005

What I think of Canadian trusts, Fri., Nov. 18, 2005, 11:30 AM

Quirks in the Canadian tax system have led to the development and exploitation by Bay Street of a new industry referred to as Canadian royalty and income trusts. Buyer beware.

I have not written much about these securities because in principle I don't agree with them. They represent prime examples of the musical chair game that the Street promotes, which is to shift risk to Mom & Pop from themselves and their corporate clients.

In Canada, there has been sufficient time for assessment of these so-called investment" vehicles. The present Minister of Finance is up in arms. He has been locked and loaded; now he is firing. The Street is trying to fire back.

Unfortunately for the government of the day, other events have led to their remaining in power on a whim and a prayer. An election will soon be called. The Trust market is suffering and there are millions of Canadian voters.

Americans who don't understand this about the Canadian democratic system is that it is multi-party based, and governments are elected for so long as they have a majority of elected representatives in parliament, up to a maximum of five years, or in the case of a minority government, as long as they have the confidence of the elected representatives of the other Parties in parliament. Canada also has a Senate, but this is kind of like a Hall of Fame, where friends in government appoint the senators.

I'll leave it to others to describe the financial structure and operations of the companies that have converted to a royalty or income trust. The literature is readily available.

There are several things that bother me about these trusts, including:

1. They are created primarily as tax avoidance vehicles for the shareholders, which in effect is the people deciding which corporations are no longer going to be subject to corporate income tax.
2. They pay out almost all their income, so their assets cannot grow, and at times their operating conditions will dictate that their assets will decline. Yet, the majority of investors are treating the income distributions as fixed income.
3. Many of these businesses are levered with debt, and when interest rates rise, their bottom line is severely impacted. That means that traders like to buy these vehicles when rates are falling, and want to sell them when rates are rising.
4. There are a limited number of companies that are suited for the royalty and income trust structure. After the first several (mostly good ones) were floated by Bay Street, there were a great many others that followed that had dubious value. Worse, the understated risk represented by the management/director teams of some of these weak ones, in the words of a former world-class regulator I know, is clearly criminal, and leading to class-action lawsuits."

ROBTV personality Kevin O'Leary, a man of considerable personal wealth, claims to have invested in over 50 of these companies, and has become dissatisfied. He refers to a growing list of Broken Trusts".

In the Thursday Nov-17-05 ROB newspaper of the Globe & Mail, the Investing column of Omar El Akkad is headlined: Canaccord develops defensive trust strategy". It refers to a 100-page report by Canaccord that tries to put the blame on government. The latter move has riled the Minister of Finance, who appeared to have lost control of his emotions in recent TV interviews. Or possibly he has been taking acting lessons in Hollywood North. Do you think?

In any event, there are a lot of players in the Canadian royalty and income trust game that have extremely opposed perspectives. There are also clearly some trusts that have substance and sustainability, as well as others that are failing, and some that have stopped distributions. And, I feel, there will be a mess of shareholder pain and litigation to follow.

I stand aside because these are (i) not pure equity plays, (ii) not all large cap and anywhere close to being on my list of the best-run companies in the world, or Canada for that matter, and (iii) they were created by people whose motives are different than those who think they are buying them for low-risk, high-yield income.

In particular, I think the risks are misunderstood and far underestimated. If the economy goes into recession and/or interest rates move much higher than they are today, the relatively short list of Broken Trusts", which I gather is about 20, will explode.

If you are participating in this Canadian trust market, I would recommend you take the advice of Canaccord (and others), as expressed in the ROB Globe & Mail article I cited.

By the way, I was founder of Canaccord in Eastern Canada, which is now Canada's largest independent (non bank-owned) broker-dealer. It is a wonderful company. In many ways, I wish I had never left. But in my personal voyage through life, I decided at that point to stop being Dream Merchant" and simply become Dreamer".

The difference between me and other dreamers, of course, is that I have been on the other side, and I have learned the game. Now, with the help of the Blogosphere, I can sit back and publish my own commentary, and share my experiences.

There is nothing wrong with being Dream Merchant or Dreamer " just as long as you use prudence and stick to the high road.

One final recommendation: I strongly suggest you trash those U.S. investment newsletters " as popular as some are " that have been hyping these Canadian royalty and income trusts. What's behind that is a stock promotion by unethical and unworthy management and vested interests in these Canadian companies, paying under the table stock and/or other consideration to the U.S. so-called investment letter editors to get your attention, and build your appetite. They sell greed, and you should know by now who ends up getting slaughtered.

In one case of a U.S. newsletter that was sent to me by an American reader for review, I forwarded it to a Canadian securities commission. The reply I received from the investigator was that the American newsletter editor/owner is well known to the authorities, and has been charged or sanctioned in some fashion. That is just the tip of the iceberg.

I hate to end a downer article on the age-old advice: If it sounds too good to be true; it usually is."

But, since it applies so much to this situation, I will.

Posted by Posted by Bill Cara on November 18, 2005 11:30:43 AM | Category: Cara Today in the Market

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