The Globe and Mail, Report on Business
Published November 17, 2006

"It's like a spotlight in the darkness... it focuses on what's moving and everything else is blotted in the darkness."

Those words came from Eric Sevareid in a PBS documentary on Edward Murrow (Good Night, and Good Luck) a few months back. Mr. Sevareid, who was one of "Murrow's Boys" early in his career at CBS and became a renowned journalist in his own right, was talking about the news in general, but I think it's applicable to Canada's most illuminated business issue - income trusts.

Certainly there has been plenty of movement for the spotlight to follow since the Finance Minister's bombshell. Investment portfolios, business strategies and investor confidence were all set in motion. But as we adjust to the new reality for income trusts, it's time to move away from the spotlight and poke around in the darkness.

I'm referring to what's really going to drive income trust returns going forward - business fundamentals. The tax implications have been analyzed from every direction. The outlook for interest rates has been considered. But what rarely gets talked about is whether these companies can maintain their level of profitability.

In his column last Saturday, Derek DeCloet pointed out that Canada has been on an unprecedented, and dare I say unsustainable, roll when it comes to profit growth. That roll has coincided with the emergence of the income trust sector. As a result, the concept of corporations dressing themselves up as providers of steady income - a high yield bond in effect - has not yet been stress tested.

Sure, there have been lots of little blowups, but that's just the law of big numbers and a hot IPO market. With hundreds of trusts out there, there will always be some that don't work out, especially when the investment bankers have been reaching to the bottom of the barrel for new issues. But in general, the sector has been unscathed. The robust economic environment has allowed investors to focus on yield and tax efficiency without having to worry about how the companies are doing.

It's worth remembering, however, that the income from a trust is a distribution of profit, and profit comes after all the bills are paid and the plant and equipment is maintained. How the Yellow Pages Income Fund deals with the new tax regime is important, but of much more significance is whether its big yellow books can fuel profit growth while the electronic competition attacks from all sides. What really matters to holders of the Aeroplan Income Fund is whether the company can keep up its pace in the face of a growing legion of dissatisfied members (including yours truly). And the yield on the Davis + Henderson Income Fund won't matter much if management can't modernize the business model before cheque usage falls off a cliff.

Certainly some high quality, less-cyclical companies (like the ones I've just mentioned) will skate through a softer economy and maintain or grow their distributions. But we shouldn't kid ourselves. A tougher environment will have its impact. Mature businesses may start to deteriorate more rapidly and find it more difficult to get back on track. In those cases, distributions may be permanently cut. For more cyclical companies, profits will disappear and could turn to losses. In some cases, the turnaround may extend beyond 2011.

In the past, trusts have been priced too much on their current yield and not enough on the value of their business. Professional investors have become a bigger part of the trust market and the valuation premium related to "yield chasing" has narrowed. But there may still be some premium left to chew through. As these securities start being properly valued (as corporations with a four-year tax holiday), there will be parts of the trust sector that go through a grinding adjustment.

For example, in the past a slow-growing, mature trust with a 10-per-cent yield and price/earnings ratio of 15 was viewed as attractively priced compared to a government bond yielding 4 per cent. Going forward, it will be viewed as expensive when compared to similar companies trading at P/E ratios of twelve times.

So now is the time to cut through the politics and emotion and make decisions based on the same methodology you use for buying or selling all your equities. If the trust is fairly valued based on its profits and prospects, then there's no urgency to buy or sell. You can keep collecting the income. If the trust looks cheap based on the fundamentals of the business, then it may be a good time to add more to the holding, depending on your circumstances and overall portfolio. The third scenario is the hardest to stomach. If the trust valuation cannot be justified, then you should sell, even if it's already down a whole bunch.

The impact of Mr. Flaherty's announcement has been swift and jolting. The impact of a slower economy and deteriorating business fundamentals will be more gradual, but perhaps no less profound.