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Mathew Ingram

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Don't be a yield pig

Mathew Ingram

TORONTO (GlobeinvestorGOLD) — The rather unflattering term for them in financial advisory circles is "yield pigs" — investors who are so enamored of high-yielding stocks that they will put their money into just about anything provided it has a high-enough yield. Investing in a high-yielding stock without looking into the company behind it is a bit like getting into the bomb-disposal business because it pays well, and the result is the same in both cases: you run the risk of getting burned.

The desire for high yields isn't surprising. Both Canada the United States have been benefiting (or suffering, depending on your perspective) from record low interest rates for several years now, ever since the investment bubble of the late 1990s blew up in everyone's face. That has left investors who put their money into boring but dependable places such as money-market instruments and government bonds looking at returns in the low single digits. Hence the interest in higher-yielding — but still arguably safe — investments such as income trusts and similar vehicles.

In a nutshell, income trusts can afford to generate higher pay-outs than dividend stocks or bonds because they have tax advantages that make it possible for them to do so. It's worth remembering, however, that the yield on an income trust or bond is a little like the price-to-earnings ratio on a stock — it is simply the future payout from that investment divided by the unit or share price. Just as a P/E ratio that is too high can be a signal that all is not well with a company, a yield that is too high can also be a sign of bad things to come. Hence the old adage: If it sounds too good to be true, then maybe it isn't true.

Take a look at a few recent losers, such as Hot House Growers Income Fund, or Heating Oil Partners Income Fund. The former had a yield of about 12 per cent not that long ago — until the bottom fell out of the North American tomato market, and prices for the company's products fell by more than 40 per cent. The income trust suspended its monthly distributions (which are not the same as stock dividends, since they represent in part a return of capital) last August and the price of the units went into free fall. Heating Oil Partners also looked relatively attractive, with a 15-per-cent yield, until the company cut its distributions by about 20 per cent. A month later, it suspended them entirely due to the soaring cost of fuel oil.

The same thing happened to several real estate investment trusts or REITs, who got slammed by the loss of business in the wake of the SARS outbreak in 2003. Legacy Hotels REIT chopped its distributions and then suspended them altogether. The company argued that it was hit by unforeseen events, which is true — but analysts who follow the company had also been arguing for some time that the trust's payout ratio was too high, and that it was unsustainable. Something similar happened to Clearwater Seafood Income Fund, which cut its distributions in January, after maintaining for months that they were reasonable. The company said it decided to move to a more "prudent" ratio.

The easiest way to tell whether the trust you have invested in could be a candidate for distribution surgery is to look at the payout ratio — the proportion of the trust's free cash that is being distributed to unitholders. If it is much higher than 85 per cent or so, many analysts say you should be concerned, particularly if that continues for more than a quarter or two. With a ratio that high, a trust leaves itself very little room to manoeuvre if something unusual or unexpected should happen, and that can lead to the company taking on debt in order to maintain its payouts — which is often the last gasp before those distributions get cut or suspended.

UBS analyst George Vasic has developed a measure he calls "true yield" to determine what are the best dividend-paying stocks, and it's something that income trust investors might want to think about as well. Mr. Vasic looks not only at yield, but at the number of shares outstanding — which takes into account share buybacks, another way that company's return money to shareholders. True yield takes the dividend payout and subtracts the annual growth in shares outstanding over three years, and also looks at the dividend growth rate. In other words, it doesn't just matter how high the payout is, it matters whether it has increased or not and whether the company uses other methods to return surplus cash to its shareholders.

The moral of this story? Don't be a "yield pig." Think about more than just how high it is — like where it's coming from, and whether you can count on it to continue for the foreseeable future.

Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.

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