Blogs & Comment

Interview with a fund manager: income trusts

It's been almost six months since income trusts lost their tax exempt status. Leslie Lundquist explains what's happened since.

For the last five years Calgary’s Leslie Lundquist, co-lead manager of the Bissett Income Fund, has been living with uncertainty. She’s made her name buying and selling income trusts for Bissett Investment Management, but after Jim Flaherty’s October 31, 2006 announcement that these tax efficient vehicles would have to convert to corporations, she wasn’t sure if she’d have a job past the January 1, 2011 conversion deadline.

The deadline has come and gone and not only is Lundquist still employed, but her fund continues to operate just as it did before. The fund—which will soon be renamed the Bissett Canadian High Dividend Fund—still holds many of the same names it did during its income trust days, but she’s now able to add other high yielding investments, such as banks.

I spoke to Lundquist to find out what her job is like in a post-income trust era, why people are searching for yield and what people need to look for in an income producing stock.

How has your job changed since January?

I’m still doing the exact same thing I did through the past decade managing the Bissett Income Fund. It still has largely the same companies in it now as it did before, but instead of income trusts it’s common shares. The biggest change is that we added a few traditional larger cap dividend payers in the portfolio. We sold some of our lower yielding income trusts at the end of 2010 and we added some major banks like Royal Bank and CIBC.

You couldn’t buy banks before?

We could have, but it wasn’t really part of our mandate. Everyone knew we were an income trust fund, and for most of history yields on trusts were higher than yields on banks. Now we can own anything that has a fairly high dividend yield, so banks, and other large-cap blue chip companies, made it into our investible universe. We were selective—we sold some smaller cap, more economically sensitive names that are expensive and bought CIBC and other companies that have struggled a bit.

How has your fund’s dividend yield changed since January 1?

Broadly speaking it’s gone down (in December it was 6.27%, as of May 31 it’s 6.12%), but that’s more because the capital value of companies has gone up. In some cases income trusts cut their distributions, so we did lose a bit of yield, but for the most part it’s more about prices going up than dividends going down.

Are more people searching for yield today?

We are hearing that everyone wants yield. That’s partly based on demographics (retirees seeking income) and partly based on low bond yields. If you really want yield, bonds aren’t easy to buy anymore. Also, during the financial crisis, it was very hard for people to sell anything for income so they were really happy to have a good dividend yield. Even if the market stayed depressed for a long time, as long as dividends came in investors could still pay rent and buy groceries. When we go into weak periods it’s nice to be able to get dividends off a stock and know that you can live off income and don’t have to sell anything.

Are people too yield hungry?

Yes, but that isn’t exclusive to today. High yield can be a good thing as long as there are high free cash flows, but it can also be bad in the sense that a business is paying out too much and will have to cut the dividend. Investors have to discern whether or not this is a good opportunity or a value trap. With yields generally low because of the run up in prices, people who are going for the highest yield are at a greater risk now.

How do you find the good companies?

We focus on the stability of the cash flow that underlines the dividend. We ask ourselves, how economically sensitive is this business? Is it in a stable niche or not? Is it in a reasonably competitive environment or not? How much of the company’s cash flexibility is used up by the dividend? We want the company to be able to afford the dividend, but it has to have enough cash left over to grow the business in a meaningful way too. So look at the payout ratio and the stability of cash flow, or the stability of earnings.

What about debt?

With the worst of the financial crises behind us, we don’t have any businesses today that we think are having trouble getting financing. At the same time, if a company has a heavy debt load, there may come a time when all the cash needs to go to service the debt. Take a hard look at that. There doesn’t have to be no debt—there can be some as long as the company is stable enough. You don’t want a cyclical business with a lot of debt.

How is the former income trust market valued these days?

Overall it’s had a really good run over the past four years so we don’t find many things today that are really cheap. The cheap companies are inexpensive because they have a specific risk attached to them. And you have to decide whether you want to take on that risk.

Some of the names we think are inexpensive today are smaller cap companies that are former income trusts. You have to get comfortable with the risk associated with small-caps though. But broadly speaking, the market is fairly valued today.

What about real estate investment trusts?

REITs make a lot of sense. They’re cash flow machines in many cases. They do have to put capital in the ground, by building, but after that a passive landlord collects rent. Land value also tends to go up over time. Buildings do depreciate, but you can almost always get a building rented if you’re willing to go to market levels of rent. It’s a logical way to produce income. So we like it overall.

We are aware that if borrowing rates start to rise it won’t be as easy to make nice spreads between what REITs borrow at and what they buy at. So they may not have as much cash flow to pay out. So that’s a worry and we’re sensitive to interest rates. But the market is well positioned to get past reasonable interest rate increases.  

The REIT market is pretty hot right now though. Are there opportunities for investors?

Yields have gone up a bit—most Canadian REITs raised dividends somewhat, but prices have gone up much more than that, double-digit amount in some cases. So they are fairly valued, but if you’re comfortable that interest rates will remain low for some time, it still makes sense to pick high quality REITs.

Do you miss the income trust market?

In some ways I do because it was so fascinating to see all the ways that trusts could operate to maximize the tax efficiency of their structures and see why people loved or hated trusts. But overall it doesn’t make a difference. There’s no doubt we’ll march on in this new environment.