Oil royalty trusts are one type of investment that requires extra due diligence and before investing
On January 1, 2011, Ottawa imposed a tax on distributions of income trusts and royalty trusts. (Royalty trusts are a form of income trust. They profit from royalties associated with the sale of oil, natural gas or minerals.) The new tax put income and royalty trusts on an equal tax footing with regular corporations.
Virtually all oil royalty trusts then converted into conventional corporations. But some are still worth investing in—and investors will want to evaluate them with the same criteria.
Oil royalty trusts were a form of income trust. Income trusts were a type of investment trust that held income-producing assets. Canada offered special tax treatment for income trusts for many years. They flowed their income through to their unitholders, without paying much if any corporate tax. Investors paid tax on most of the distributions as ordinary income (although some distributions qualified as a tax-free return of capital).
Oil royalty trusts involved far more risk than most investors realize. This is why we recommended so few of them (and why we managed to find some real gems among the ones we recommended).
To review, royalty trusts were investment products that profited from royalties on the sale of production from natural resource companies. Oil royalty trusts profited specifically from oil.
The 2011 tax changed resulted in virtually all oil royalty trusts converting into conventional corporations. However, the basic tests we used to ferret out good investments in trusts, and to reject bad ones, still apply today to the former oil royalty trusts.
In evaluating investments, many investors focus on what we’d call “investment outputs,” like earnings, dividends, cash flow, return on equity, sales growth and so on. These are all important, of course, but you shouldn’t focus on them to the exclusion of what you might call “investment inputs.”
Investment inputs are harder to work with than investment outputs, since it takes a judgment call to determine their risk or value.
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To give you a better idea of what we mean, here’s a list of a dozen investment inputs that we look at before recommending any former oil royalty trusts:
Do you have any doubts about the integrity of the insiders? If so, stay out. Negative news about a former oil royalty trust should be investigated.
Was the former oil royalty trust a new issue, or an existing company that had undergone a trust conversion? New-issue former oil royalty trusts tend to be riskier than converted companies. A new issue is riskier still if it has been cobbled together from a group of companies that were bought and pooled to create the new issue.
Did the royalty trust buy its assets in the midst of a boom, or did it own them for some time? Bidding for assets in the midst of a boom tends to be risky.
How much debt is the former royalty trust carrying? If former royalty trusts carry too much debt in relation to their assets, their dividends can fall more sharply when their business hits a snag.
Is the business dominant, or at least prominent, in its industry? Former oil royalty trusts that are not significant players in their industries face higher risks.
How much of its cash flow is the former oil royalty trust paying out? Paying too much leaves a former royalty trust vulnerable to a cut in dividends. This can have a devastating effect on the share price.
Has the former oil royalty trust’s cash flow and profitability shown acceptable performance in relation to the rest of its industry? If a former oil royalty trust can’t make money when business is good, when can it make money?
Are there any special factors worth considering? With former oil royalty trusts, you need to look at how long its reserves are likely to last, as well as any other special factors.
Is the former oil royalty trust the subject of a lot of favourable broker and media attention? If so, investors’ expectations may be too high, and that leaves the stock vulnerable to a steep downturn when there is any hint of bad news.
Is the former oil royalty trust’s current and prospective yield high enough to justify the risk? On the other hand, a very high yield may signal danger rather than a bargain.
What has your experience been with former oil royalty trusts? Have they been profitable for you? Share your advice in the comment section below.