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All-Canadian Trust Guide:
our annual ranking of Canada's best and worst income trusts

A year ago we decided to guide our readers through the murky world of income trusts. To shed some light on the subject, we ranked 100 of the largest income trusts in our first annual All-Canadian Trust Guide. We used entirely objective criteria and assigned each trust an A, B, C, D or F grade depending upon how its numbers stacked up. We figured that our top-rated trusts might provide you with a few good starting points for your own research.

We're pleased to say that our humble efforts yielded solid returns. Our top-of-the-class trusts those rated either A or B gained an average of 29.7% (and that's without reinvesting distributions) since we did our ranking. We think most investors would be delighted with nearly a 30% annual return.

How did we do in comparison to the market? Since there is no generally accepted index for the income trust sector, it depends upon which benchmark you choose. Probably the fairest comparison is to the Barclays Advantaged S&P/TSX Income Trust Index Fund. That fund produced only a 28.1% gain over the same period, meaning our method of selecting trusts added nearly two percentage points of value.

Our picks look even better compared to the average trust in the Bloomberg database, which yielded a total return of only 19.1% over the last twelve months. By that standard, our top-rated trusts finished nearly 11 percentage points ahead of the pack.

We caution readers that the income trust market was a volatile place last year.Your experience depended entirely upon where you sat. Bubbly prices for petroleum propelled oil and gas trusts to huge gains. Financial trusts (think REITs) also enjoyed big advances. But returns weren't nearly as good in other sectors. In the consumer trust area, populated by retailers, restaurants and the like, 21 trusts fell by more than 15% and seven lost more than 50% of their value. Investors who bought the worst of these trusts at their highs got a rude surprise particularly if those investors thought that they were putting their money into conservative bond-like income generators. Most trusts have much more in common with risky stocks than with solid government bonds, and many investors learned that lesson the hard way over the past year.

Looking ahead, we suspect life could get very interesting for trust investors. The party in the oil patch may continue if oil prices stabilize or spike higher. On the other hand, if oil prices weaken, carnage awaits. Rising interest rates could also bite into returns if more generous bond yields woo investors away from their infatuation with trusts. But we are the first to admit that we have no special ability to predict oil prices or interest rates. Instead we analyze trusts based on their individual characteristics and their relative merits.

To do so, we've dug deep into the numbers and graded Canada's top 100 trusts on their ability to provide healthy distributions for a reasonable price. Although we've used some high-powered math to arrive at our ratings, the results can be understood by anyone who's ever read a report card. The best trusts earn an A. Good trusts pick up a B. Solid but unspectacular trusts get by with a gentleman's C. Bottom-of-the-heap trusts go home with a D or even an F.

That faint humming sound you hear as you read our tables is all of us at MoneySense urging caution. Sure, the returns of our top trusts were spectacular last year. But we are not repeat, not saying that you can make a fortune by buying every A trust and dumping every F trust. The market isn't nearly that predictable.

What we will say is that A-rated trusts deserve your attention. They have the ingredients for success over the long haul. On the other hand, you better be careful when it comes to bottom-of-the-class trusts. You may get lucky and blunder into a short-term gain, but our method wasn't designed with a quick flip in mind.

Our grades are based purely on the numbers. We didn't factor in our personal opinions about a sector or a specific trust. Instead, we scoured the Bloomberg database, which provides background financial information on all sorts of trusts. We restricted our ratings to Canada's largest trusts by market capitalization, then trimmed the initial list because some trusts have been around for less than a year or lack the robust cash flow data we need for detailed analysis. (Keep this in mind if you don't spot your favorite trust on our list.) Finally, we doled out marks based on three criteria:

Yield

The more money a trust puts in your pocket, the better. We gave high marks to any trust with a distribution yield of more than 5%. A 5% yield is relatively modest by trust standards but it is much better than that provided by most stocks. Just remember that pocketing a distribution is not the same as collecting a dividend. For one thing, you may pay more personal taxes on distributions than on Canadian dividends, thanks to the additional tax breaks that were lavished on Canadian dividends in this year's federal budget.

Reliability

We like it when a trust is paying a high yield, but we like it even more when we feel confident that the trust's underlying business is in good shape and that it can continue to pay its distribution. To ensure our top-rated trusts are operating with a cushion of safety, we awarded high marks to trusts that pay out less in distributions than they generate in cash flow.

We gave trusts additional marks if they used low amounts of debt, since trusts deep in hock are riskier than less leveraged trusts. We measured each trust's reliance on debt by calculating its ratio of total debt to total unitholders' equity, then comparing that figure against the trust's peers in the same industry.

Value

We awarded the highest marks to trusts trading at low prices in comparison to their cash flow. We measured this a couple of ways, because while we wanted low price-to-cash-flow ratios in an absolute sense, we also wanted a trust's price-to-cash-flow ratio to be low compared to other trusts in the same industry. By using both an absolute and a relative measure of cheapness, we rewarded trusts that provide lots of cash flow for a reasonable price. We also wanted to buy lots of assets for a low price and higher grades went to trusts with moderate-to-low price-to-book-value ratios.

Putting our marks together we arrived at final grades for each of our 100 trusts. Only 10 earned an A, but 20 managed a solid B. We think both classes are well worth your consideration. But don't get too caught up in which trust got an A and which got a B. Feel free to go even further afield in the hunt for trusts with unique or intangible features that may not be reflected in the hard numbers.

Before trading on the basis of our grades, you should make sure the trust's situation hasn't changed in some important way. Be sure to read the firm's latest press releases, its regulatory filings, and recent newspaper stories to get up to speed on all of the most recent developments. It is also wise to limit your trust exposure to a small portion of your well-diversified portfolio. Loading up only on trusts might be exciting but it is also a risky proposition.

The best way to use our grades is as a starting point for your own research. Don't feel confined by our approach. Instead, look up the characteristics that mean the most to you. If you're interested in trusts with a high earnings yield and low debt, it's a simple matter to grab a pencil and underline a few prime choices. Like any screening strategy, the purpose of our trust ranking is to help you distill a sea of data into a few good ideas, which can then be investigated in more detail.

Download the 2006 Top Trust table

From the Summer 2006 issue.

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