The Globe and Mail

DEREK DECLOET

Benjamin Graham, the father of value investing, had a saying about the stock market: “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Those words can be read in two ways: as a plea for investors to focus on a company’s fundamentals, or as a warning on the dangers of following the cues of momentum investors, whose “votes” can quickly drive entire industries to new market highs — or lows.

With Mr. Graham’s law in mind, we can’t help but wonder what he would say if he were watching the hot money sloshing into Canadian income trusts as never before. The momentum players have set up camp in the sector, with a wonderful effect on prices and trading volumes.

Nowhere is their arrival more obvious than in the oil patch, where any company that is a trust, or could become a trust, or whose chief executive officer can spell “T-R-U-S-T,” is greeted with everything but a ticker-tape parade.

As an example, take Builders Energy Services Trust, which was brought to the public market in late January. Builders, as its name suggests, makes its money providing services to oil and gas companies — moving rigs around, renting equipment and so on.

Not that its business plan really matters to the people who bought in on the IPO and have already sold at hefty gains. Half of the shares sold in the Builders offering were flipped in the first two days of trading, for profits of 30 per cent or more. As for those long-term investors who’ve stuck around for the whole three weeks — how quaint is that? — they’ve been rewarded with a 49.9-per-cent gain. We don’t necessarily equate this sort of activity as the market equivalent of playing a slot machine, though we couldn’t help but notice that Builders’ ticker symbol is BET.

It takes a pretty dour person to spoil this kind of enthusiasm. Fortunately for contrarians, Peter Best is just that sort of person.

With energy trusts about to join the S&P/TSX composite index, Mr. Best, who toils as an analyst for Credit Suisse First Boston, decided it was time for a fresh look at the sector. He released his findings Thursday. By Friday morning, he was on his way to becoming downtown Calgary’s most hated enemy since Pierre Trudeau.

Mr. Best did not use the phrase “house of cards” to describe the energy trusts’ sky-high valuations. He did, however, use the words “crash,” “collapse,” and “bubble.”

There is not a lot of science in his bearish call. It is not based on a brave forecast that oil prices will fall to $10 a barrel, or natural gas will plunge. Mr. Best simply looked at the amount of free cash flow the trusts produce (even at high energy prices), the amount they’re paying to unitholders, and observed that the former falls short of the latter.

How have they been making up the difference? Two ways, Mr. Best says: by borrowing the money, and by issuing new units to a public that just can’t get enough of them (to hold for the long term, bien sûr).

“This equity expansion means that companies require more and more cash to maintain even a flat distribution — in effect, new capital is being used to pay old capital,” he writes. Wouldn’t Charles Ponzi be proud?

This cannot be sustained, naturally, and will come to a quick end if the trusts’ bankers start to get nervous. Mr. Best sees the hedge funds and arbitragers selling (or short-selling) six to 12 months before the inevitable distribution cuts. The individual investors who followed them into the sector won’t immediately realize what’s happening, the analyst says, and might wait to sell until the cuts actually happen — “i.e., when it is too late.” Any correction will be “dramatic” and a bona fide crash is “not inconceivable.”

Having stuck his neck out this far, there is not much he can do but wait for events to unfold, and duck the arrows in the meantime. “I’m sure sooner or later I’ll start to get some abusive phone calls.” Sooner or later he’ll be proved right, of course. By then, the hot money will have moved its votes to other candidates.

Bargains outside sector: Bank yields smaller, but have better growth potential

Ian Karleff

Financial Post

Some market observers say that the mushrooming world of trusts is starting to resemble the late 1990’s tech boom, as massive sums of new money chase index-beating returns of the past three years, and initial public offerings soar out of the gate.

On the flip side, what this is doing is creating value in other neglected areas such as banking.

“I do think there is an analogy to what happened in 1999-2000 when all the money was going into tech, so valuations got attractive elsewhere,” said Murray Leith, director of investment research at Odlum Brown Ltd.

“Starting in 2000 there was a bull market in anything but technology. There was a tipping point back then and eventually money flowed out of technology and into other parts of the market, but you had to be patient, and let the tide run against you.”

Mr. Leith says banks are one sector in “unprecedented value territory” and even though the big six pay more modest yields of 2.9% to 3.74% (roughly half the yield of quality trusts) they have grown dividends at a compound annual rate of 15% in the past five years, which is better than trusts.

“It is quite possible that the popularity of trusts will extend itself but I’m going to take a two-to-five-year view and I think you will do better on stocks that pay a decent but lower dividend than a trust, but have more growth potential than a trust,” said Mr. Leith.

To be fair, income trusts are not just fluff and dreams, like much of what eventually became the tech wreck of 2000. Trusts are real businesses paying out real cash to unitholders. Yet it’s the insatiable public interest — and the admission by many that the asset class is expensive and only getting dearer — that gives it a tech-type appearance.

Who would have thought back in 2000, when trusts were pariahs and technology the must-have investment, that underwriters in 2005 could put a positive spin on a yarn-maker called Spinrite Income Fund?

It’s IPO was worth $203-million yesterday, with the units spiking 11% in the first day of trading and a quarter of the units changing hands.

Or how about K-Bro Linen Income Fund, launderer of towels and sheets for hospitals and hotels, up a similar amount in its first day of trading with roughly 59% of its units traded in four trading sessions.

IPO spinners and flippers are having a field day, while value investors are carefully surveying the pricey trust landscape and finding value not in the big, soon-to-be-index-eligible names, but the beaten-up trusts trading below book or net asset value.

“You have to sift through them … there are some that are vastly overpriced,” said ABC Funds’ value portfolio manager Irwin Michael.

Energy Savings Income Fund, with a current yield of 4.97%, is a good example of that. It has raised distributions 18 consecutive times, while its units have risen 740%, but it is running into tougher times as commodity-price volatility and consumer naivete runs its course, said Veritas Investment Research analyst Anthony Scilipoti.

Energy Savings trades a mere 75 basis points above the 10-year Government of Canada bond (implying a low-risk investment) but in Mr. Scilipoti’s analysis, its margins and potential customer base are shrinking while competition is increasing.

Furthermore, at a stock price of $18.50, investors are pre-paying for 2.7-million new customers or roughly 10 years of growth, which is bold considering the trusts faces smaller profit margins and higher costs to acquire customers, said Mr. Scilipoti in a research report last month. (The stock closed yesterday at $17.80, up 5 cents)

The expectations built into Energy Savings’ units are a reminder of the Internet days when a gaggle of research firms put out-of-this-world targets on Internet or wireless user growth, and stocks that were poised to tap into this growth were bid sharply higher.

In a similar albeit less salient move, First Associates’ analyst Barbara Gray added $2.50 or 19% to her Yellow Pages Income Fund target yesterday, for a potential 12% gain from here on the back of her firms’ lowering of their long-term forecast yield on the Canada 10-year bond to 5% from 6%.

Meanwhile, few investors truly understand how sensitive trusts are to government bond yields, but you only need to look at the historical performance of TimberWest Forest Corp. to answer the question.

In January, 2000, TimberWest traded at $10.85 and paid a 10% yield, while the 10-year note offered a yield of 6.25%. Move ahead to January 2005 and the units were trading up to $16 with a yield compressed below 7%, and the 10-year note down to 4.21%.

“So if the 10-year goes back to 6.25%, the unit price will go back, and you have to ask yourself, ‘How many years of distributions will you give up in that scenario?” said Odlum Brown equity analyst Ross Turnbull.

However, won’t the same hold true for bank stocks?

“If interest rates on the 10-year back up 100 basis points, the popularity of the trust sector will wain considerably, whereas I think if rates back up 100 basis points that will be reflective of a decent economy and the banks will be prospering, so there will be excitement about the banks’ growth potential,” said Mr. Leith.

AGAINST THE GRAIN The good times for the oriented strand board ( plywood substitute) market still has life, with prices expected to rebound another 9% to US$400 per million square foot in the near term, and trade at an average of US$350 in 2005, said Jennings Capital analyst John Duncanson yesterday.

This flies in the face of current analyst’ consensus which expects prices to weaken to US$246 per million square feet in 2005 because of weaker demand and a wave of new OSB capacity.

Mr. Duncanson says the consensus is wrong because single family starts will remain buoyant, and these use more OSB than multi family homes, while hard-to-get-off-the ground capacity will likely only increase 2.6% in 2005 and 2.8% in 2006, down from 4.7% per year between 2000 and 2004 (new plants can take two years to reach capacity).

Furthermore, U.S. plywood supply continues to shrink with four billion square feet of capacity shuttered since 2000, while OSB capacity growth will be crimped by fibre-supply issues, higher construction costs and new air emission regulations, added the analyst in a research report.

© National Post 2005