Ordinarily, a double-digit yield screams one thing: "buyer beware!"
When dealing with royalty trusts, it says something else entirely. More like: "That was a pretty good year."
Royalty trusts are not companies. They have no operations, no management. They are essentially financing vehicles that hold operating assets for others, typically the shareholders. Unlike ordinary businesses, almost all cash flows generated by these trusts are passed directly on to shareholders, either in the form of dividends or return of invested capital.
The most well-known publicly traded trusts are REITs (real estate investment trusts), but others abound. Many provide shareholders a cut of royalties on, among other things, equity/bond portfolios or the production and sales of a natural resource. Our focus today is on the latter -- trusts that pay royalties based on the cash flows generated by exploiting a natural resource. The majority harvest oil, gas, minerals, or timber, or some combination thereof.
Scan the landscape of royalty trusts, and you'll find two characteristics that attract investors. First, most have appreciated by more than 50% over the past year. Second, their dividend yields are massive, generally over 10%. One trust, Tel Offshore
Provident Energy Trust
After the past few years in the stock market, it isn't too hard to figure why income-paying trusts have come squarely into focus for the average investor. Nor is it any surprise that, as with most Wall Street fads, the depth of knowledge investors bring to these investments is not nearly what it ought to be. There are substantial issues here that folks must consider.
Think about it. These are income-producing properties. Why on earth would the existing owners of a cash-producing machine hand it over to a bunch of investors they've never met? It's certainly not out of generosity. Generally speaking, these folks have better uses for their money than these resources, so they cash out by creating a trust.
That said, if you're thinking of investing in royalty trusts, here are some things to look for:
Since that income stream is the main rationale for investing in a royalty trust, it ought to follow that the best investment is the one that has the highest yield, right? Not so. In fact, if there's one yield you're pretty much guaranteed not to get next year, it's the current one. Remember, these are simply formulaic payouts of a percentage of income. There's not much management discretion as there is with operating companies. If a trust earns $1 per share, it pays out 80%-99% of that (anything above 90% is pretty aggressive). If it makes $0.02, it pays out the same percentage of that. Be sure to check the trust's past dividends for some semblance of continuity.
This is crucial, and it's a reason to be wary of trusts. Unlike ongoing businesses, oil and gas fields are depleting assets -- the more you harvest, the less that remains. Eventually, the income-producing ability of the trust is tapped, at which point the trustees may choose to liquidate, or will need to retain or raise funds to make acquisitions. Neither is beneficial to existing shareholders. In many cases the higher-yielding trusts have less time to depletion of proven reserves.
Provident Energy, for example, has just 8.9 years of natural gas reserves, and less than that for liquid oils. You're getting more in the way of a dividend yield, but the assumption ought to be that if you hold on to these trusts forever, your principal is at more risk the closer the company comes to depleting those reserves. And remember that the trustees could choose to buy new properties, thus depressing current income, and increasing the risk that the new property is of lower quality than the current portfolio.
Though many trustees perform substantial hedging of commodity prices, these stocks are still generally at the mercy of the oil and gas markets. In the past four years we've seen oil prices ranging from $13 to nearly $40. Geopolitical realities mean that fossil fuel prices could once again plummet, or they could double. These externalities have an enormous effect on the payouts of royalty trusts.
And keep in mind these are sophisticated instruments. Because some of your annual dividend will most likely be treated as a return of your original investment (capital), royalty trusts have unique tax implications -- both for taxed and tax-deferred accounts. You'll probably want to get a tax advisor's blessing before taking the plunge.
All of these issues aside, there is plenty of reason to be interested in income-paying trusts. Consider those that pay a fairly stable dividend, with a longer proven-reserve duration, and that don't pay out more than 90% of income. And don't just chase the highest yield -- as with equities and bonds, the highest dividend yields can signal that things are not as they seem.
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann owns none of the companies mentioned in this article. To learn more about companies that stay off the beaten path, take a look at Tom Gardner's Motley Fool Hidden Gems investment newsletter.