In Stop Working: Here’s How You Can! and The Lazy Investor, Derek Foster advocates a strategy of putting a portion of a portfolio in income trusts and says that he expects the distributions to rise as fast as inflation. His claim that even very young investors can retire on a portfolio of much less than $1 million rests on using this strategy to boost a portfolio’s yield.

The current market turmoil has clearly demonstrated the risk in relying on income trusts. In The Lazy Investor, Derek provides the holdings in his portfolio at the time of retirement, which will allow us to analyze how his own portfolio performed over the past 5 years.

Algonquin Power Income Fund (APF.UN) – 8%
Canadian Oil Sands Trust (COS.UN) – 11%
Corby Distilleries (CDL.A) – 6%
Enbridge Income Fund (ENF.UN) – 6%
EnCana (ECA) – 7%
Johnson & Johnson (JNJ) – 10%
Livingston International (LIV.UN) – 5%
Manulife Financial (MFC) – 7%
Pembina Pipeline (PIF.UN) – 3%
Pengrowth Energy (PGF.UN) – 8%
RioCan REIT (REI.UN) – 5%
Epcor Power (EP.UN) – 4%
George Weston (WN) – 7%

He does mention that he sold some stocks not listed here and replaced them with others, but the above names make up 87% of the portfolio and the conclusions reached should largely hold true. Note that income trusts make up over 50% of the portfolio.

Assuming Derek retired with a $100K portfolio, I used the stock prices as of June 30, 2004 to figure out how many shares of each stock he owned. Then all you need is the dividend history of each name to figure out the income from the portfolio. In 2004, the portion of the portfolio under analysis would have yielded $4,863 or 5.6%. Over the next few years, the strategy was remarkably successful — dividend income grew to $5,106 in 2005, $6,212 in 2006, $7,713 in 2007 and $9,896 in 2008. In five years, dividend income from the portfolio had doubled.

But 2009 will be a year of reckoning. Four income trusts have drastically slashed their payouts (COS.UN, APF.UN, LIV.UN and PGF.UN; the distributions from the last three names today are below 2004 levels) and the cash flow will plummet to less than half that of 2008. In 2009, the portfolio will generate $4,766 (yield is 6%), which is 2% below the income generated in 2004. The portfolio has also lost 8% since mid-2004.

It is instructive to look at XIU’s performance over the same time period. XIU’s dividends have increased from 20.5¢ to 47.4¢ and its value has increased 11% since mid-2004. Meanwhile, XIU’s dividend yield has increased from 1.7% to 3.9%.

This article has 35 comments

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  2. Right now I am not a big fan of income trusts, not exactly sure what most will do come 2011 when they have to convert and it makes me a little uncomfortable holding them.
    Also because income trusts have such high payout ratios they are very sensitive in economic down turns.
    The only income trust i hold is a REIT and it’s RioCan, we used to have yellow pages income fund but sold out of it mid January, although my fiance still has some in her RRSP fund.

  3. The distribution cuts in the energy sector have been very large, reflecting the dramatic drop in oil prices. The market isn’t expecting oil prices to staay this low (look at futures closer to the end of the year) so current distribution levels for energy companies may increase as we move through the year. So it may be interesting to re-visit this post in December.

    This is also an example of why you need to understand the companies you own. For example APF.UN had a payout ratio well over 100% in the summer and once the credit crisis hit and access to capital was essentially cut off the distribution cut was almost a foregone conclusion. In the same sector Great Lakes Hydro income fund is an income trust that hasn’t cut distributions.

    Our household owns both APF.UN and GLH.UN and in the late summer I started wondering how APF.UN was paying its distribution. Unfortunately I didn’t dig deep enough to be able to see how big the distribution cut would end up being.

  4. An investment reporter at The G&M confirmed to me that Foster has rode COS.UN all the way to the bottom as well as Algonquin. In his most recent book about options he sold a slew on Citigroup & GE and had to exit his positions with losses (how much I don’t know).

    Investment risk is one of the hardest things to identify for any investor (experienced or novice) and I think it goes to show you just how important your selection criteria is before you make choices based solely on the income you’ll receive from his “recession proof” stocks; at best they are recession resistant.

  5. Income trusts look very interesting right now … maybe not the oil and gas funds but some of the power funds with long term contracts / stable cash flows are yielding well above 10%(e.g. Epcor Power EP.UN at 15.2% yield). Their debt needs looking at but even there several look reasonable. Even assuming 40% cut in distributions in 2011 when most will be forced into regular corporations and be taxed accordingly, yields could still end up 8+%. At that level, the only growth I’d want is to keep pace with inflation.

  6. Maybe Foster should have tried something else. A few years ago I heard that you could get a good yield from mortgage-backed securities :-)

  7. I wouldn’t pursue a dividend/income based approach without considering diversification accross industries and asset types. Putting it all in income trusts, MLP, REITs, BDCs just because the CURRENT yield is high is a recipe for disaster in the making.

    Some fixed income allocation to gvt bonds could also help..

  8. Canadian Capitalist

    0xcc: Perhaps. But what I find striking in a portfolio of someone who claims it’s the cash flow of a portfolio that matters is how volatile the income is. Despite what happens next year or the year after, the point I’m trying to make is that chasing yield has its dangers.

    Brad: I haven’t read his new book but just the title annoys me. If only it were so easy. Ironically, despite the market turmoil, the common stocks in the portfolio have done reasonably well. It’s the reaching for yield by overweighting income trusts that has resulted in the drop-off in income.

  9. Bogle says that the dividend yield of the stock is the risk premium of the stock. As a result, one way of determining whether the market is overpriced or not is to see the dividend yield of the market.

    For any equities, high yield suggests high risks involved. Unsystematic risk can be diversified away by using an index or by doing the calculations and analysis. oxcc made a good point that understanding the risks involved with APF.UN, he could of avoided unsystematic risk. Of course, systematic risk can not be diversified away unfortunately. Holding individual stocks require one to analyze both systematic and unsystematic risks involved. I am still learning how to do it correctly.

  10. While he obviously built a rather risky portfolio, some of these are starting to look rather attractive at today’s prices.

  11. Maybe his portfolio has taken a dive since he was so preoccupied chasing the yield on his latest book?

  12. RE: “For any equities, high yield suggests high risks involved” — is that a universally true rule? For instance many Canadian banks are offering really high dividend yields and yet most ‘experts’ suggest that our banks are pretty solid? I realize there is risk in any stock purchase but buying bank stock seems pretty low risk at least in my (novice) opinion?

  13. Novice: high yields indicate that investors are expecting the company to cut their current dividends, most of these high yield stocks carry a high risk with them, but not. The current financial crisis has seen many banks around the world go down or cut dividends but I am strong believer in the Canadian financial system they were ranked among the top in the world. Scotia Bank was ranked among top 10 in a recent global ranking reported by national post.

    I think the Canadian banks are safe with their current dividends.

  14. One of my pet peeves occurs when people lump all income trusts into one single category and paints them all as “evil”. To me, that’s kind of like saying that all stocks are evil… Or all bonds are evil. Of course, the point being that the Harper government is out to destroy the income trusts structure isn’t helping things… But to lump them all into one single category drives me crazy!

    Income trusts range from businesses as diverse as real estate, oil & gas companies, restaurants, gas stations, liquor stores, waste disposal and telephone books!!! How can anybody possibly lump them all together and paint them with one broad brush?

    As far as buying income trusts, you should use the same metrics to consider the investment in much the same way that you should evaluate whether you want to buy a stock or a corporate bond! It’s no different! Regardless of how it’s structured, you should always consider the company’s debt, the management team and their strategy (if they publish it), the core business itself as well as future prospects of the core business and of course their balance sheet and cash flow statements.

    Anyways, I hold a wide variety of REITs, I hold one mortgage pool (structured as an income trust) and a restaurant income trust. It’s just one man’s opinion, but I think the pub side of their business is stable regardless of the economic environment. I grew up in the poorer part of the country (maritimes) but saw that regardless how the economy was performing, people always somehow found the money to go out to bars and pubs.

    Despite taking a massive drubbing on all of these investments, I’m not planning to sell any of them. In fact, I’m considering using this opportunity to add some new ones to my portfolio. But I think there is still more bad news to come, so don’t think we’ve hit bottom yet… And that’s regardless of whether we’re talking about income trusts or common stocks or even preferred shares and corporate debt…

  15. Canadian Capitalist

    Jon: I would argue that holding 25%-30% of a portfolio in one stock (COS.UN in Derek’s case) is very risky however confident one might be in a company’s prospects. Actually, most of the volatility of the portfolio’s income can be traced to that one stock.

    Phil: I’m not saying income trusts are evil or should be completely avoided. I hold Yellow Pages and RioCan personally and while it hasn’t been a happy experience, it has been no different than holding stocks.

    The point is that stacking a portfolio with income trusts and then counting on the income boost to provide living expenses isn’t a sustainable strategy. It has proven to be volatile in the past and IMO, will continue to be in the future.

  16. Novice: Yes and no. Sometimes the yields are low yet high risk are involved just like 2000 and 2007. According to Bogle, it doesn’t make sense to take high risk and low risk premium at the same time. At this point, there is high risk (financial system might be collapsing, economy enter a depression) and there is a high risk premium in terms of high dividend yield. Bogle says it make sense to purchase equities, because the high risk premium compensates for the high risks involved.

    Ray: I hope you are right. JPM has a really high yield right now and everyone assumes that JPM will survive this crisis. I guess the same logic can used on RBC and BNS. My main concern with Canadian banks is that their Canadian domestic portfolio might go wrong (credit card default, mortgage default, line of credit default as people might use bankruptcy to destroy their excessive debts). A friend reminded me that value investors are usually right but value investors buy way too early.

  17. Umm, EconStudent – you must have not heard the news about JPM?

    If the Canadian banks can show they are still profitable, then I’m sure the dividends will be safe. If we see reports this week and they’re bad, my guess is those ‘safe’ dividends won’t be so safe anymore.

  18. Not to drift off the topic too much but Canadian banks have a payout ratio of about 50-65% or 70% based on 2009 forcasts and those arent very strong forcasts but as EconStudent said let’s ay profits are worse than expected they have more than enough wiggle room, even if they miss estimates by 20% they wont cut their dividends, I think it would take a lot for them to cut their dividends at this point, I talked about this topic on my blog last week

    Income trusts are very volatile and they payout ratio very high, due to the structure of the trusts so it has it’s unique risks.

    CC: I completely agree, they are good to have but counting on the income to provide living expenses just too risky.

  19. Let’s say we have two stocks, Stock A and Stock B. Stock A yields 15%, Stock B yields 4%. Now let’s say we have two investors with equal amounts of money to invest. Investor A invests all of his money in Stock A, Investor B invests all of his money in Stock B. One year later Stock A cuts its dividend to 8% and Stock B raises its dividend to 6%. Which investor is in better shape?

    • Canadian Capitalist

      Mike: Let’s assume all things are equal. i.e. A and B exhibit a similar earnings history, have the same valuation, there is no tax on dividends etc. There is now no difference between the two stocks: A has simply decided to distribute more of its income to its owners and B has decided to reinvest earnings in the business. Assuming investors in A and B reinvest their dividends, neither owner is better off or worse off than the other.

      But instead assume that both consume all their dividends. A is counting on the dividend income to pay the bills and so is B. Now A is worse off because he is experiencing a drastic cut in income but B is better off because his income has increased instead.

  20. I always found it amusing that “high yield” in the equity or income trust space is generally thought of as a good thing and buying strong earnings while the same term in the fixed income space means you’re buying junk bonds.

    Its the same concept really, just a different perception in (many) retail investors eyes.

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  23. I think CDN dividend-paying stocks are the way to go, but not income trust solely. You need to be balanced – simple as that.

    Have you ever heard of anyone getting “rich” on just one stock or investment source? Not I. Most often, folks have a diversified and multi-vehicle approach for wealth creation, whether it be owning a few real estate properties, good safe blue chip stocks, or various high-yield investments.

    Mark in Nepean.

  24. I hope Derek writes another book to let us know how he is coping with the recession. I’m sure he was a little dissaponited to learn APF.UN cut their dividends by almost 75%. I’m pretty sure no company is really recession proof. If we ever make the shift towards grren energy, APF.un should be a great long term investment IMO.

  25. Great article. I have always questioned the amount of income trusts in Derek’s portfolio especially with them converting to corporations in the next few years. I am assuming he had these in his portfolio before the Conservatives changed the rules.

    Overall though I like his strategy but IMO he overlooked and miscalculated some key factors.

    1. I understand Derek looks at dividend/distribution that can withstand recessions and isn’t concerned about share value but in this market typical recession proof companies aren’t even safe. To his defence, who would have predicted these markets.
    2. Derek main worry is inflation which is understandable. If his dividends don’t increase, inflation will destroy his income. One factor he doesn’t discuss is divorce. With divorce 50/50, it’s a bigger risk than inflation IMO.

    It’d be interesting to see if Derek posts and updates on how he’s actually doing and how he’s coping/changing his strategy in today’s market.

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  27. I think the key culprit to Derek Foster’s massive income collapse is high concentration rather than high yield.

    People who didn’t chase yield a couple of years ago are hurting just as much. Think Manulife, GE, Wells Fargo, Pfizer, Teck Cominco… These were low yielder just a couple of years back, and Manulife was the most owned stock on the TSX at one point.

    Also there are 2 rational reasons for high yield. One is to compensate for the potential of a dividend cut, and the other reason is to compensate for slow/no growth. Pipelines and ultilities would fall under this category.

    To protect from income loss, it’s essential to diversify, and I don’t mean buying 50 different oil and gas trusts.

  28. I live in the USA . I have been whale following , performance chasing, and bird watching as I have accumulated 3000 units of GLH.UN since the Dec Bought Deal Financing (BDF) closed @16 $ CD. I suppose I see the dividend chase as a side effect to the bird being knocked down below it’s intrinsic value of +/-.85-.90.
    Canada has the best managed economy with the strongest banking system left on earth. As oil goes so will go the Loonie! In the meantime I will continue accumulating units of GLH on any further weakness near or below $14.25CD. The Loonie could slip to .65 according to some technical strategists but others like Kathy Lien of Global Forex feel the market forces will support the .75 support level as a low.
    GLH is gravy at these exchange rates for a US investor. You have the advantage of whale trailing as Bruce Flatt of BAM used a subsidiary to dump $75 MM into this trust at $16CD/unit. This means his minions of forensic accountants have already judged what the fair market value for this trust is. In addition $65 MM of the BDF went directly into acquiring existing new generating capacity that became accretive in Feb.
    Performance is #1. GLH just reported record!!! results in the 2008 operating period. Record generation, gross and net profits! Not many companies had those kind of results in 2008. a
    After making a new 52 week low near $14CD last week GLH has rocketed higher to add on another 2.2% yesterday and finish at $15.38CD.
    We now await the declaration of the March distribution next week. While it is unlikely due to the BDF unit dilution that there will be any distribution increase forth coming, it is certainly possible given the revenue off the new generation that there could soon be one. All that aside TODAY St Paddy’s Day we reflect on a few strains of Danny Boy…. “But come ye back when sunshines in the meadow…” We now have the strongest quarter of hydrology upon us as we leave behind the weakest hydrology qtr. As Ice and snow pack melt and low pressure systems working further north as they cross the continent as well as the Nor’easters moving further west into the “Downeast”, we can anticipate a record 2nd qtr and the units to continue to stand their ground and move higher.
    Oil should move to $52 US$s in anticipation of Summer driving demand. In addition while difficult any move above 4US $s /MM~BTU in Nat Gas would be an additional boost to the Loonie. While it may not Soar the bird can be expected to move back above sea level for the Summer nesting season. This should drive my effective yield against my cost basis well over 7%. From $16 CD I am sure we will see GLH moving steadily higher towards a premium to Mr Flatt’s investment. Hey what do I know I am just a Whale follower?

  29. Canadian Capitalist

    FJ: Agree. IIRC, Derek had 20% to 30% of the portfolio in a single income trust — Canadian Oil Sands. I don’t care how good an investor someone is, it is pretty stupid for a retiree to have that much in a single stock.

  30. i’m not sure the portfolio above provides a lot of insight into any particular strategy. not only is diversification nonexistent (as has been observed many times), but the period of study is *really* atypical. earnings worldwide were above trend in
    ’04, and accelerated sharply through ’06.

    there is also the issue that you _can’t_ evaluate the significance of dividend policy without looking at the value (not price. value) of the shares. it’s all well and good to say “i bought it for the div” but companies that pay a high dividend by/while issuing lots of new shares, or simply chopping the balance sheet for parts, by definition are guaranteeing a disruption of the divs in the future.

    i don’t know the first thing about many of these companies, and i’m not at all trying to insinuate they are behaving in this way. it’s just not unheard-of in high dividend payers, and needs careful examination.

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  32. A lot of investors are worried that fixed income is no longer a viable investment. This is primarily due to the global collapse of bond yields, but also investor misconceptions about seeking yield. Is there a ‘bond bubble’? If so, what can be done to avoid getting caught when it pops? You can read the full article here:

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