Royalty Trusts

This is the third article in the my dividend investing series. Actually most of these current income investments do not pay out the so-called traditional dividends. For royalty trust companies, they pay out royalties to the owners, instead of dividends. For investing purpose, there is not much difference except the origins of the income. However, for tax purpose, they are very different. The royalties that you receive, you need to file Schedule E, and pro-rate your gross royalty income, severance tax, administration expenses, interest, and depletion. It is quite involved when you deal with the taxes. However, the upside is that more often than not, you won’t pay any (current) taxes, besides the tiny amount of interest on Schedule B. You will pay taxes in the form of capital gain when you sell eventually (or not sell).

Assuming that you don’t have the problem with the tax complexity, many of the royalty trusts reward their owners with usually 8% to 12% yield. Most of the royalty trusts are based upon their production of the natural resource assets, such as oil, gas, or coal. The advantage is that these stocks will be tied to the corresponding commodity prices much more compared to MLPs (Master Limited Partnership), under the assumption of no hedges are taken by the company management. This correlation to the commodity price gives you added performance when the commodity is performing well, but will give you additional downside when the commodity is not doing well. In any case, it is more of an inflation hedging investment compared to MLP. Also, because of the fluctuation in the commodity price of their production, the royalty trust pay-outs can also fluctuate and are less stable. The fluctuation may be smoothed out by the company management, but it will fluctuate nevertheless.The other problem with royalty trusts is that as the resource base of the commodity is produced and depleted, they face the definite need of repleting the resource base. The success of the repletion relies on a good management to either raise capital in the stock market or in the debt market to finance purchase or exploration of the new resource base. And it needs to be done in such a fashion that the existing shareholder interests are not uneconomically diluted.

One of the most mentioned royalty trusts is SJT (San Juan Basin) which I have owned since 2003/2004. It is recommended time after time on many internet articles because of its vast resource base. SJT has a forward yield of 7.6% (assuming that the next 12 monthly pay-outs are $0.233 x 12 = $2.796), or a trailing yield of 9.3%. The stock price I used to calculate yield is based on the closing price $36.98 on May 26, 2006.

For more information, here are two very informative article links on both MLP and royalty trusts:

  1. MorningStar Investing Classroom
  2. Financial Advisor Magazine

To read my previous two articles on dividend investing, here are the links:

  1. My dividend investing ($11775.91 in 2005)
  2. Master Limited Partnership – Great Dividend Savers

I will probably have two more articles, next one on REIT. In the last summary article, I will give out some past/current stocks that I have bought, most of which have dividend yields north of 7.5% (except MLPs), with additional upside from the increasing energy costs.

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