As with any investment, selection is key when buying trusts. The biggest mistake an investor can make is to simply look for the royalty trusts that offer the highest dividend yields with little regard to their underlying businesses. Often, the trusts with ultra-high yields are fundamentally weak in some way. As a result, their distributions are likely to be unsustainable.
Here are some of the most important considerations to keep in mind when buying trusts:
Payout Ratio -- This ratio measures the percentage of a trust's earnings that are paid out as distributions. For example, if a trust earns $1 and pays out $0.85 in distributions in a given year, then its payout ratio would be 85%. We prefer to invest in trusts with relatively low payout ratios, particularly when it comes to energy-related trusts. Such trusts are holding back some of their income so that if earnings or cash flows fall, they won't be immediately forced to cut their dividends. This offers a nice cushion against commodity price volatility.
Manageable Debt -- As we explained, Canadian trusts are able to take on debt or equity financing to expand their businesses. Although it's normal and quite healthy for a trust to have some debt, occasionally a trust can get into financial trouble by taking on too much debt.
Reserve Quality -- Most oil and gas related trusts own fairly mature reserves that offer predictable production. But a key metric to watch is reserve life -- how many years of production a trust can pump from its existing reserves. Trusts with low reserve life will likely be forced to issue more units or borrow more money to acquire new reserves. These acquisitions can be both expensive and dilutive to existing unitholders, especially when energy prices are high.
Interlisted -- Although it's not hard for U.S. investors to buy Canadian stocks, we tend to prefer trusts that are listed both in Canada and on one of the major U.S. exchanges as American Depositary Receipts, or ADRs. For U.S. investors, these trusts are easier and cheaper to purchase. In addition, up-to-date headline and quote information is more readily available. Furthermore, interlisted trusts are more likely to have experience dealing with a U.S. investor base. As such, their investor relations departments should be better able to handle queries from U.S. owners.
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