When readers of my 12% Letter took their position in October 2006, Westshore sported an 11% dividend. Once the world caught on to the story, investors “chased the yield,” making Westshore behave like a growth stock. That pick returned 80% in the first 18 months.

Today I’m going to show you why Westshore was the perfect income play… and how you can spot the market’s best income investments. Let’s get started…

To qualify as a perfect income play, a company must 1) run a simple business, 2) be unable to expand its operation, 3) enjoy a huge “moat,” and 4) pay very little (if any) taxes. Here’s how Westshore measured up:

First, Westshore’s business couldn’t be simpler. The railroad brings the coal to Westshore’s Vancouver terminal. Westshore removes the coal from railroad hoppers, piles it up using a system of conveyor belts, and then reloads this coal onto ships. Westshore never owns the coal. It simply earns commissions from the coalmine it serves.

Simplicity is important because it’s easy to identify the risks in a simple business. All businesses carry risk, but if you can identify them, you can make a more accurate assessment of a company’s value.

Would you rather make a bid on a vast corporation with myriad operations and opaque accounting – say, Citigroup – or a coal terminal like Westshore? I always give more value to dividends from simple businesses than from complicated businesses.

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Second, Westshore has no way to expand its business. The terminal sits on the head of a spit in the waters south of Vancouver. The railroad tracks run around the perimeter of the spit. Westshore piles up the coal in the center of the spit. There are two docks, a pair of gantry cranes, a parking lot… and just enough room for a couple of prefabricated cabins where management runs the operation.

It may sound odd to say we’re looking for companies that can’t expand, since most investors are drawn to growth. But we’re not looking for growth. We’re looking for income. Expansion is a distraction… and often a big waste of money.

Businesses that can’t expand have the most focused management teams and pay the safest dividends. We want a company that pumps cash into its dividend, not its capital-expense budget.

Third, Westshore has a huge business moat, meaning there are significant barriers to competition. Westshore exports metallurgical coal. Forges use “met coal” to make steel. There is no substitute for Westshore’s coal. The world will always need steel… And the coalmine has enough coal to last for another century. A couple of other terminals export coal from western Canada. But they’re too small to make any dent in Westshore’s revenues.

We want a business that enjoys a wide moat. Moats protect castles from invaders. In business, moats protect dividends.

Finally, Westshore is an income trust. As long as these companies pay out all their earnings to shareholders, they don’t have to pay tax. Companies that don’t pay tax have more money to return to shareholders.

Of course, our Westshore position was a victim of its own success. The share price appreciated so much, its yield diminished and a modest price correction triggered our stop loss… As much as I love Westshore’s business, it’s still too expensive to leap back into today.

But you can find similar opportunities. Look for simple, straightforward businesses that pay few taxes, enjoy a healthy competitive advantage, and are unlikely to spend their money on anything but your dividends.

Good investing,

Tom

P.S. Westshore Terminals was my first pick in The 12% Letter, and it’s my best-performing so far.

Source: The Perfect Income Investment