Tuesday, August 7, 2007

Income Trusts – NAL Oil and Gas – Part I.

In turbulent times, investors have a propensity to avoid volatility and find the security of assets which exhibit lower price fluctuations. In times of uncertainty, investors become more risk adverse and move from greed to prudence. Fear comes later at market cross points.

Speculators and traders just love volatility because it provides opportunities for large gains in a very short period of time. The Market’s evaluation of risk quickly moves “on the other side” and soon enough the prevalent short term market trend becomes expensive. For example, if you were looking to short using puts today, you would find the premium quite expensive. When the trend was bullish, they were giving them away…

As I write this, it is clear to me that the long term trend is still bullish and the short term trend is bearish. As a general rule, I do not short a long term bull market. There will be a lot of opportunities later if the larger trend does reverses. But I do time the market in the sense that I did take my profits when it was clear to me that the market psychology was reversing. I showed some of the indicators I watch in previous posts. As markets correct, I transform into a different being. From a short term trader, I become more and more an investor with a longer investment time horizon with plenty of cash to re-invest when the time is right.

Having taken profits, I was then confronted with the question of where do I park my money? Cash currently yield 4.75% at my broker. Once I give the governments its share, there is not much left. If this is a correction, (and that is all I can assume right now) why not find high yielding securities whose correlation with the market is low and whose market price is at more attractive valuation levels. Income Trusts may fit the bill.

But there are a lot of risks to Income Trusts. I will highlight a few of them:

-1- Liquidity risk – These companies do not trade many shares during a day. For example, NAE.TO has traded an average of 230,000 a day over the past 60 days which is good. But many trade below 40,000 shares a day…
-2- Small capitalization risk – Being small, they will tend to be influenced by what happens to smaller cap stocks. It also means that institutions might avoid owning these stocks. As an example, there are 49 institutions which hold about 2.1% of the shares outstanding at NAE.TO. A corollary is that if institutions do no hold the stock, then the sell side research will be low to inexistent. There is currently no broker covering NAE.TO for example (coverage: provide an earning estimate). There lies an opportunity. If you can do your own research, you might have an edge before the crowd discovers a situation.
-3- Commodity and Currency risk – Many will experience financial results dependant on the price of commodities like natural gas, oil , iron ore and so on. As most commodity are priced in $US, they will experience exchange rate risk as well. For example, the rise of the $CDN has been detrimental to revenue growth, cash flows and earnings this year.
-4- Government Intervention risk – Income trust generate distributions (dividends) to their shareholders which are in a form of deferred capital gains, dividends and interests for a taxation purpose. Halloween 2006 was a day when the Federal government decided to change the rules of the game, and income trusts crashed and have been weak ever since.
-5- Economic and cyclicality risk – All companies are sensitive to contractions and expansions in economic activity. Income trusts are not immune.
-6- Stock market risk – When markets are in bear mode, all stocks are affected by the tide.

Many Income trusts will be reporting earnings between August 7 and 9, 2007. You can expect fireworks near the end of the week. Although, I see an opportunity in natural gas in the foreseeable future, it would be unwise to make any commitment before one has had a chance to evaluate the impact of the 2nd quarter on the various investment opportunities.
As a general rule, I find it too dangerous to purchase positions before a company has released their statement during earnings season. So what am I to do?

NAL Oil and Gas released their earnings report last week and it was generally quite good. Fundamentally, it has a good balance sheet, a low payout ratio (pays a low % of cash flows as dividend). On an annual basis, it pays $1.92 on a market price of $13.09. That’s a current yield of 14.67%. Usually that is a yield level associated with companies which are in trouble and where the market estimates that the distribution may be cut in the future. But that’s not the case for NAL especially given their recent financial results. I believe the reason is that 100% of this trust’s distribution is taxable as interest income. If you give 50% to the government in taxes, that means the after tax return is more in the 7.3% in my pockets.

Full Disclosure: I own a position in NAE.TO and my position can change anytime without notice.

Absolute Price Chart

Relative Strength Chart

I leave you with two blank Point and Figure Chart of NAE.TO. Tomorrow, I will discuss the Plan, the strategy and tactics for this stock.

The Word

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