Ottawa’s plan to press ahead with its “tax fairness plan,” which calls for income trusts to be fully taxed beginning in 2011, means a death watch could be underway for the $250-billion industry that has attracted the savings of more than a million Canadians.

Four years from now, “there will be no rationale in terms of enhanced value for a business trust to exist. Tax parity will ensure that,” says Diane Urquhart, an independent investment analyst based in Toronto.

“After 2011, there will be no tax advantages to having a trust structure. Therefore, the trusts will go back to being corporations,” says Urquhart, a former financial services analyst who also once ran the research department at Scotia Capital Inc.

Urquhart believes income trusts will continue to exist past 2011 only if regulators don’t require that trusts be marketed and priced on the basis of cash yield and not, as happens now, on cash yield plus return of capital. She believes the current system overstates yield.

If trusts were required to report on the basis of cash earnings, she says, the yield would be lower and thus reduce the attractiveness of trusts.

Still, a number of outcomes are possible between now and 2011, as legislation enabling the Oct. 31, 2006, plan has yet to be passed. Furthermore, analysts suggest that, in the meantime, there are interesting investment prospects in the trust universe — despite the doom and gloom.

Dirk Lever, an analyst with RBC Capital Markets in Toronto, suggests trusts should be valued on the basis of their underlying fundamentals, not on their yield. A good business is one “that has a growing valuation, whether it be a corporation or a trust,” he says.

In particular, Lever says, good businesses are characterized by the same themes: secure margins; high market share; part of a stable industry; a conservative balance sheet; and a conservative payout ratio. “The things we like as a corporation, we like as a trust,” he says.

In a recent report, Lever and a team of more than a dozen analysts listed three so-called “best ideas” among large-cap business trusts: Toronto-based Energy Savings Income Fund, Montreal-based Yellow Pages Income Fund and Toronto-based Teranet Income Fund.

Lever says Energy Savings, involved in long-term natural gas sales to consumers and small commercial operations, is “one of the best growth prospects in the business trust universe and is still attractively valued as a growth story with little debt.”

Yellow Pages, which owns Can-ada’s largest telephone directory publisher, has “solid operational momentum” so it can generate 5% annual average growth in distributable income, says Lever.

As for Teranet, which runs the land registry system in Ontario, he says, the fund has a “high degree of predictability” in its revenue stream. Lever believes distributions could withstand even a 25% decline in real estate transactions.

The report assigns an above-average risk to Energy Savings but an average risk to the other two trusts.

Among small-cap trusts, Lever favours three business trusts: Liquor Stores Income Fund, which operates retail liquor stores in Alberta; Davis + Henderson Income Fund, a supplier of programs to customers who offer chequing accounts and lending services in Canada; and First National Financial Income Fund, which owns an originator, an underwriter and a servicer of predominantly prime residential, multi-unit residential and commercial mortgages.

Only companies with low business risk “are truly acceptable for the highly leveraged business trust structure. The only business trusts worth investing in are growth trusts,” says Barbara Gray, a Vancouver–based analyst at Blackmont Capital Inc.

She expects to see few business trusts around in 2011. Many will either be acquired by private-equity funds or convert to corporations, and others could go out of business as they are too small to attract investment. About three-quarters of business trusts have a market cap of less than $250 million.

Gray says investors should take five investment characteristics into consideration before deciding which trusts merit their attention:

> Ebitda Margin. At least a 30% margin is required, as that level reflects a strong competitive position.

> Debt Covenants. This is a measure of the risk creditors are prepared to take. Gray says investors should look for a debt/EBITDA ratio of about 3:1. Anything less could create creditor concern.

> Industry Sector. In general, cyclical trusts should be avoided in favour of defensive ones.

@page_break@> Market Capitalization. Avoid small-cap trusts and concentrate on larger ones.

> Distribution Growth. Staying with proven growth trusts is the best policy.

Based on this, Gray’s list includes Aeroplan Income Fund, which owns Air Canada’s rewards program; BFI Canada Income Fund, which owns a waste-management company; and Teranet and Yellow Pages, both of which have Standard & Poor’s Corp. Sr-2 ratings. She has a “sell” on Aeroplan because it’s expensive, a “buy” on Teranet and a “hold” on Yellow Pages.

Urquhart strongly suggests investors not give in to the temptation to pay premium prices for trusts that provide part of their apparent high returns by paying out 100% of their income. By paying out all its income “the trust has lowered its growth prospects, resulting in an offsetting impact on its value,” she says. “The market gives a lower P/E multiple for low-growth entities. An income trust with proper accounting and disclosure will not command a premium price.” IE