A weekly examination of the thinking behind a specific trade in the stock, bond or currency markets.
With no more high political drama to toss Canada's income trust sector about, it's back to trading on fundamentals.
Between Sept. 19 and Dec. 5, business trusts lost $10-billion, or 17 per cent on a cap-weighted basis, according to Canaccord Capital Corp. However, most of those losses were regained, and business trusts are now trading 7 per cent below Sept. 19 levels, it added.
However, even though business trusts have had a bumpy ride as of late, Canaccord has developed a trading rule that has proved profitable in each of the past three quarters.
Canaccord grouped trusts based on cash yield -- the conventional measure of trusts -- as well as economic yield. Economic yield is Canaccord's estimate of trailing 12-month pro forma sustainable distributable cash flow divided by the current market price. Graphing economic versus cash yield, Canaccord identified how much of a trust's normalized distributable cash flow it's paying out. A diagonal line across the graph shows where trusts would lie if they paid 100 per cent of normalized distributable cash flow. Companies below the line are paying more than 100 per cent, and may face problems sustaining their distributions. Trusts above the line are paying less than 100 per cent, and may be able to raise distributions, providing they aren't highly leveraged.
"Despite the interim volatility, the "above the line/below the line" trade worked for the third consecutive quarter," Canaccord analyst Chris Rankin said in a recent report to clients.
Using the trade rule and analyzing leverage, Canaccord listed a number of trusts with the potential to increase distributions. A&W Revenue Royalties, Second Cup Royalty Income Fund and Newalta Income Fund all have implied payout ratios of less than 95 per cent and pro forma leverage below two times (pro forma leverage is Canaccord's estimate of where leverage will be one year from now relative to earnings before interest, taxes, depreciation and amortization, or EBITDA).
Looking ahead at the business trust sector as a whole, Canaccord said the large-capitalization business trusts are likely to lead the market as a result of index inclusion, better liquidity, and more consistent financial engineering. The small-cap trusts with higher quality are likely follow-through candidates, albeit over a longer time frame, it added. Approximately one-third of issuers, however, are described as "busted trusts" by Canaccord. Those are trusts that have both cash and economic yields above 12 per cent. Possibilities for such trusts include distribution cuts, convertible debt issues, "going-private" transactions or bankruptcy.
North West Co., UE Waterheater and Yellow Pages are Canaccord's current favourite trusts. None is formally rated by the company.
© The Globe and Mail
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