September was another good month for the Canadian Edge Portfolios. The markets began to lose their fear that the US housing slump would spread to the broader economy and hence to Canada. The Canadian dollar broke above parity with the US dollar. And the Canadian economy continued to surge, riding the long-term bull market in natural resources.

Meanwhile, investors got a value alert when the Abu Dhabi National Energy Co offered a premium of nearly 40 percent to buy a middle-of-the-road, natural gas-weighted trust, PrimeWest Energy Trust (PWI.UN, NYSE: PWI). That’s another stark reminder that trusts backed by good businesses are still selling for a song and that more takeovers lie ahead.

At the same time, however, some got yet another harsh reminder that not all trusts are bargains. The complete meltdown of Enterra Energy Trust (ENT.UN, NYSE: ENT) and lesser declines in Pengrowth Energy Trust (PGF.A, NYSE: PGH) and Wellco Energy Services Trust (WLL.UN, WLLUF) following dividend cuts demonstrates there’s still considerable danger in the energy patch, with the natural gas production sector flat on its back.

Outside energy, the falling US dollar is causing considerable hardship for several trusts that do business here. The most exposed are suffering both from a drop in the Canadian dollar value of US cash flows and competition, as their costs rise versus US-based rivals.

Stressful times like these always differentiate the strong from the weak. That’s what I expect to see for the rest of the year.

The common denominator of all strong trusts is a solid and growing underlying business. The Conservative Portfolio and Aggressive Portfolio selections differ widely in terms of business and financial risks. All, however, are at the top of their respective sectors for sustainability. Just as important, management has the strategy to ensure they stay there.

Conservative Is Cool

For many US investors, trust investing has always begun and ended with oil and gas producers. That’s a shame, considering trusts outside the sector account for most of the best performers in recent years and pay far-more-reliable dividends as well.

Some readers have asked how to get started in trusts. The answer is to look every issue at the High Yield of the Month, which highlights the best buys of the month. After that, look at the Conservative Portfolio, which is listed at the end of this section.

The Conservative Portfolio is an all-star list of the best nonenergy trusts. All have sustainable, growing businesses backed by strong balance sheets. And all have the strategies in place to pay big distributions for years to come, even if they’re taxed as corporations starting in 2011.

Well-managed energy infrastructure trusts are good examples. Unlike energy producers, these companies don’t really care if oil and gas prices move up or down. All they’re concerned with is the flow of energy. The more that moves through their assets, the higher their cash flows.

All three of my selections—AltaGas Income Trust (ALA.UN, ATGFF), Keyera Facilities Income Fund (KEY.UN, KEYUF) and Pembina Pipeline Income Fund (PIF.UN, PMBIF)—continue to run their assets well. Moreover, they’re expanding holdings with a combination of acquisitions and new construction. The more they add, the greater their cash flows grow.

At some point, the industry will overbuild. When that happens, the fees for using a pipeline or processing facility will decline, and so will cash flows of infrastructure owners. At this point, we’re still a long way from there.

For one thing, demand for Canadian energy—particularly oil sands output—continues to rise. And getting it to market means building more pipelines, storage facilities and other infrastructure. For another, there are still considerable barriers to entry, from rising capital and construction costs to difficulties siting new projects because of opposition from local residents.

We’re still not seeing much speculative construction either. Rather, builders are lining up hard interest and even signing contracts before committing to move ahead. As a result, capacity is only increasing where demand is being demonstrated with financial commitments. As long as that’s the case, the risk of overbuilding is nil for infrastructure trusts. In fact, new projects are almost a sure thing to increase cash flow and distributions.

AltaGas was dealt a setback last month when it canceled a pipeline project. But it quickly turned lemons into lemonade by purchasing 50 percent of a gas storage project in Ontario, its first in the province. Unitholders got an unexpected bonus in late August, when the trust spun off another piece of its former gas utility unit AltaGas Utilities. The amount received was one share of AltaGas Utilities for every 100 units of AltaGas Income Fund. 

For those who owned less than 5,000 units of AltaGas, the distribution should have been paid in cash by now, with no 15 percent withholding. AltaGas Income Trust, which increased is distribution 2.9 percent last month, is a buy up to USD28.

As I pointed out last issue, Keyera has been profiting richly from the boom in natural gas liquids (NGLs). NGLs have been in high demand because the low price of natural gas—their feedstock—has made them cheap to produce, even as high oil prices have boosted their selling price. That’s kept the trust’s facilities operating at full tilt and at high margins.

Last month, Keyera announced it would expand its NGL processing and storage facility in Fort Saskatchewan by 37 percent in a project expected to cost CD70 million to CD80 million. The first additional storage cavern is expected to come on line in the second half of 2009 at a cost of CD18 million.

When the project is complete, Keyera will have a very strong position in infrastructure throughout the oil sands region. And a recent private placement of debt is pretty clear evidence it’s having no problems financing its moves either.

The shares have been solid performers, in part because management has made no bones about paying big dividends long after 2011. But yielding more than 8 percent and selling for just 78 percent of annual sales, Keyera Facilities Income Fund is still a bargain up to USD19.

Pembina Pipeline’s 9 percent-plus distribution boost this summer was the third major increase since the Conservative government’s trust tax move was announced last October. That’s about as clear a declaration of intent as possible that management will keep paying out big long after 2011.

And it’s got a long string of new projects to produce the cash flows in coming years to do it. Pembina Pipeline Income Fund yields more than 8 percent and is a buy up to USD17.

My recommended electric power generation trusts have a similar strategy to the infrastructure and pipelines trusts: Build fleets of clean power plants, and sell the output to extremely creditworthy customers under long-term contracts, which factor out fuel cost risk and build in rate increases. Plants tend to be small and carbon neutral and, therefore, favored with government subsidies as well.

The result is a group that generates tons of cash flow, much of which can be sheltered from taxation after 2011. Algonquin Power Income Fund (APF.UN, AGQNF) and Atlantic Power Income Fund (ATP.UN, ATPWF) enjoy even more protection. Some two-thirds of Algonquin’s income comes from US power plants and water treatment facilities and is, therefore, shielded from taxes. Meanwhile, Atlantic is a “staple share,” combining debt with equity; as such, it’s entirely exempt from trust taxes in 2011.

Both trusts yield in the 10 percent range and pay monthly. And both are in the process of further expansion that will boost future cash flows and very likely distributions. Algonquin Power Income Fund is a buy up to USD9.50; Atlantic Power Income Fund is a buy up to USD12.

Boralex Power Income Fund (BPT.UN, BLXJF) took a hit last month after management announced it wouldn’t sell itself now, the latest result of a strategic review begun shortly after the trust taxation announcement. But although some were disappointed about the lack of a takeover in the near term, the trust remains healthy and management affirmed the decision wouldn’t “affect the Fund’s objective to ensure stable and foreseeable distributions.”

In my view, a takeover or merger is still likely sometime before 2011, barring a change in the tax law. Until then, however, there’s every reason to keep buying high-yielding Boralex Power Income Fund up to USD10.

Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF) had a very active month. Its Leisureworld unit announced the acquisition of long-term care facilities totaling 1,127 beds. The deal follows the trust’s two-track growth in the carbon-neutral power production and long-term care businesses, both of which generate massive, transparent cash flow.

The trust’s shares remain cheap at 1.24 times book value because of continued bad press about its parent, Macquarie Bank. One of the bank’s divisions does manage the fund, but Macquarie Power & Infrastructure is a separate entity, with assets ring-fenced from those of the bank. That independence is assured by the oversight of a four-member board of trustees, three of whom aren’t connected to Macquarie.

Buy Macquarie Power & Infrastructure Income Fund , yielding more than 10 percent, up to USD12.

Right REITs

Last month, I added two more REITs to the Conservative Portfolio—Artis REIT (AX.UN, ARESF) and Canadian Apartment Properties REIT (CAR.UN, CDPYF)—to go with prior holdings Northern Property REIT (NPR.UN, NPRUF) and RioCan REIT (REI.UN, RIOCF). These REITs aren’t invested in the US or in operating businesses like hotels. As a result, they’re wholly exempt from prospective trust taxation in 2011.

All are beneficiaries of Canada’s strong property market and enjoy occupancy rates and rent growth well above US rivals. They’re also financially stronger and yield 2 to 3 percentage points more.

As for future cash flow growth, the quartet is having no trouble adding new properties in prime locations, which are immediately accretive to cash flow. Nor is financing a problem, as Artis’ CD75 million offering of units last month again illustrates. The trust will use proceeds to finance some CD140 million in ongoing property acquisitions, mostly in energy-rich Alberta.

That focus on the energy patch makes Artis the most-exposed REIT when the cycle inevitably comes to an end. Fortunately, that’s likely many years away. In the meantime, the trust is growing rapidly and debt is relatively low at just 45.8 percent of book value. Artis REIT has run up a bit since last month, but it’s still a buy up to USD18.

Canadian Apartment Properties REIT announced the purchase of eight apartment buildings last month in British Columbia and Alberta. The move continues the REIT’s expansion into western Canada, boosting British Columbia and Alberta to 5.3 percent and 5 percent of the overall portfolio, respectively.

Coupled with solid occupancy and rent growth in the old core eastern Canada properties, the REIT is headed for faster cash flow growth and more distribution growth in coming months. Buy Canadian Apartment Properties REIT up to USD20.

As for Northern and RioCan, they remain the sector’s safest bets. In fact, they’re far more solid than any REIT on this side of the border and yield twice as much as the highest-quality US fare. RioCan boosted its distribution another 2.3 percent last month. Buy RioCan REIT and Northern Properties REIT up to USD25.

The remaining Conservative Portfolio holdings hail from a range of businesses but have two things in common. First, their core businesses are solid and growing and generate piles of cash flow. Second, their management is committed to paying out big distributions to perpetuity, no matter how Ottawa decides to tax them. Note Yellow Pages Income Fund (YLO.UN, YLWPF) is reviewed in depth in this month’s High Yield of the Month.

After 2010, Bell Aliant Regional Communications Fund (BA.UN, BLIAF) will enjoy the same tax sheltering capabilities US rural telecoms do now. That’s a huge pool of depreciable assets and other noncash expenses. In addition, capital expenditures for maintaining the network are very low at just 16 percent of revenue, providing more for distributions.

The game in rural wireline telecom is to up-sell basic phone customers to advanced services like broadband at a faster pace than they drop their basic copper-line phone service. And based on the trust’s first year of results since being spun off from BCE and Aliant Communications, it’s succeeding. This month, Dominion Bond Rating Service (DBRS) affirmed Bell’s stability rating of STA-2 (high), the highest of any trust except fellow Conservative Portfolio member Yellow Pages.

Bell does face one major uncertainty in coming months relating to former parent BCE’s pending takeover by a private-capital consortium: BCE beneficially owns 44 percent of the trust.

Under the terms of the deal, Bell Aliant was specifically ring-fenced from providing any form of security or guarantee to the new debt issued for the BCE takeover. New management could conceivably find a way to boost debt at the unit to get more cash out of it, possibly requiring a distribution cut. Were immediate cash a priority, however, it would be more likely to sell shares than to do something to depress the value of its equity stake.

In any case, Bell Aliant’s basic business is solid. The shares have recovered everything they lost in the wake of the trust taxation announcement and more. But Bell Aliant Regional Communications Fund remains a solid buy up to USD32.

Arctic Glacier Income Fund (AG.UN, AGUNF) had a very strong summer because of a series of acquisitions it made in the US. The Canadian dollar value of US revenues has dropped. But because the trust’s facilities are also located here, there was a corresponding drop in expenses and no loss of competitive edge versus US rivals. Arctic also hedges a substantial amount of cross-border cash flows.

The result is the trust remains in good shape to continue paying big distributions and finance further growth. And with more than 70 percent of income now coming from the US, the trust’s dividend-paying future for 2011 and beyond is very bright indeed. Yielding almost 9 percent paid monthly, Arctic Glacier Income Fund is a buy up to USD14.

Energy Savings Income Fund’s (SIF.UN, ESIUF) strategy is also heavily focused on expansion in the US. That will correspondingly reduce the trust’s tax exposure in 2011 and beyond. Also, because it does business in the US—rather than exports—lower expenses offset currency related drops in revenue.

The trust hedges its US margins, and this country is still only a little more than 12 percent of income. The impact on the bottom line is minor and is more than offset by sheer revenue growth. And all US revenue is currently being reinvested in the country, so there’s no impact on distributable cash flow.

The primary risk is that Energy Savings will be unable to attract and hold customers to its electricity and natural gas marketing programs. So far, however, that hasn’t been a problem, and cash flow and distributions continue growing. The result: Energy Savings Income Fund is a solid buy up to USD16.

Continuing to operate a strong, growing business is the primary requirement for a trust to stay in the Conservative Portfolio. As long as I’m comfortable that’s the case, I’ll hold on no matter what the market does. But if I get an inkling something may be amiss at the business, I’ll cut ties in a hurry, no matter what the return and how long I’ve held the trust.

Timber Troubles

I’m not quite to the point of cutting ties with TimberWest Forest Corp (TWF.UN, TWTUF). The trust has one of the most valuable timber reserves anywhere in North America, as well as some extremely prime real estate to sell. And for the first time, management appears to have the expertise to exploit both.

What has me concerned is what appears to be an increasingly acrimonious struggle between the trust and the primary unions who harvest its lands. The steelworkers union had already been on strike for several weeks, with little progress from ongoing negotiations, when it issued a series of very public charges against TimberWest. The union alleged the trust used illegal logging techniques and sustained abuse to both workers and the environment.

The company immediately responded by threatening a lawsuit unless the union retracted its statements. After discussions, the union allegedly agreed to do so but then refused to hours later. As a result, the litigation looks set to go forward and a resolution to the strike seems further off than ever.

The primary result of the strike is a shutdown of production for the foreseeable future. The summer months are rarely good times, and any cash flow shortfall is likely to be more than made up for by a planned sale of prime real estate from the company’s valuable Vancouver Island properties.

Sooner or later, however, these disputes will have to be resolved. The alternative is to sell all its properties and/or cut its distribution, which is entirely debt interest. That day of reckoning may be years away. Until this is resolved, TimberWest Forest Corp is a hold.

Instead, look at Acadian Timber Income Fund (ADN.UN, ATBUF), which is fully producing on its lands in eastern Canada. The trust yields about half a percentage point more than TimberWest, pays monthly and is backed by parent Brookfield Asset Management, which owns 45.3 percent.

The main difference between the two trusts is that TimberWest is a staple share and, therefore, exempt from 2011 taxation. Acadian is an income trust, and will face some burden. A take over by parent Brookfield—itself a major buyer of timber properties in the past year—remains a real possibility, as are spinoffs of assets. Acadian Timber Income Fund is a buy up to USD12.

If you don’t want to buy Conservative Portfolio holdings individually, pick up one or both of the Fund Alternatives listed in the table below. Both are closed-end funds trading below their net asset value (NAV).

EnerVest Diversified Income Trust (EIT.UN, EVDVF) trades at a nearly 14 percent discount to its NAV. One reason is management’s plan to increase assets again by offering owners of some 125 different individual trusts the opportunity to swap their shares for those of EnerVest.

That move is certain to benefit manager Avenir Diversified Income Fund (AVF.UN, AVNDF) with higher fees. But it may not pass muster with shareholders, who are unhappy about the big discount to NAV. Management continues to repurchase shares on the market to close the gap. But despite plans to buy up to 10 percent of total float, the going has been slow.

In my view, the fund is still worth holding for three reasons. First, it has the largest and best-diversified high-quality portfolio in the closed-end fund trusts universe, and management has done a good job running it over the years. Second, it continues to pay an extremely generous yield that’s backed decently with its holdings’ distributions and relies relatively little on leverage. Third, there aren’t many places to get a buck’s worth of assets for 86 cents. Buy EnerVest Diversified Income Trust up to USD7.

My other fund choice is Select 50 S-1 Income Trust (SON.UN, SFYIF), which is essentially a portfolio of the largest, best-established trusts. The goal is for the entire fund to rate Standard & Poor’s highest trust stability rating of S-1. The effect, however, has been a fund with a relatively high degree of correlation to the broad-based S&P Toronto Stock Exchange Trust Composite, which is tracked by the graph posted in In Brief.

The fund’s yield is considerably lower than EnerVest’s and the discount to NAV is lower at just 4.2 percent. Nonetheless, it routinely posts better gains when trusts rally. If that’s your kind of play, Select 50 S-1 Income Trust is a buy up to USD12.50.

Aggressive Stars

The majority of my Aggressive Portfolio comprises oil and gas producers. Their underlying strategies are discussed at length in this issue’s Feature Article. ARC Energy (AET.UN, AETUF) is highlighted in High Yield of the Month.

Note that Advantage Energy Income Fund (AVN.UN, NYSE: AAV) has completed its purchase of Sound Energy. Those who formerly owned Sound should be sure they have their cost-basis information handy for 2007 tax season. Note on Aug. 14, 2006, Sound was formed from the merger of NAV Energy and Sequoia on a 1-for-1 basis, spinning off exploration company Sure Energy. The value of that spinoff is CD79.07 cents per Sound share.

Three of my picks hail from the related energy services sector: Newalta Income Fund (NAL.UN, NALUF), Precision Drilling (PD.UN, NYSE: PDS) and Trinidad Energy Services Income Trust (TDG.UN, TDGNF). The market has absolutely mauled this sector of late because of the collapse of shallow gas drilling in Canada. We’ve seen a flurry of distribution cuts, including a pair at Precision, and sharply lower share prices for all three.

It’s hard to envision a real recovery for any of this trio, without a solid rebound in natural gas prices. Newalta has diversified aggressively outside the energy patch, taking its environmental cleanup expertise to a range of industries in Atlantic Canada. The latest of these is a deal to buy Canada’s largest integrated lead battery recycling facility, located in Quebec.

The plant is currently running at only 50 percent of capacity, providing abundant opportunity for Newalta to use its national facility network to drive additional batteries to the facility. That’s the kind of “tuck in” opportunity the trust is famous for, and it augurs strong cash flows ahead.

Until gas recovers, however, Newalta’s distribution should be considered at some risk. So should Precision’s, despite its very low debt, solid asset base, growth in the US and decent current dividend coverage in the face of abysmal market conditions. Even Trinidad—which has dodged the worst of the woes with its focus on deep drilling and the US market—should be watched closely from quarter to quarter.

Why stay invested in this industry? Because this trio has proven its ability to survive a year of the worst industry conditions in memory. As a result, there’s little downside risk left, even if the sector slump goes on a while longer. Valuations are low, and the sector is even more leveraged than the producers to the inevitable recovery in Canada’s gas patch.

We’ve suffered greatly with all three. But I’m convinced those willing to hang on and tolerate possible additional pain in the near term are going to clean up with them in the next 12 to 18 months. Accordingly, Newalta Income Fund is still a buy up to USD25, Precision Drilling to USD25 and Trinidad Energy Services Income Trust to USD18 for patient, aggressive investors.