My view then was the worst had been priced into the trust market within days, if not hours. We still had at least four years more of outsized distributions, and in any case, great businesses would continue to grow and reward shareholders, regardless of how they were taxed.

At the time, a lot of people disagreed strongly with me. And unfortunately, they wound up cashing out at precisely the lows. During the past 12 months, 25 of the 29 trusts in the Canadian Edge Portfolios have thrown off total returns of at least 20 percent in US dollar terms.

Ironically, the only three Portfolio losers in the past year had nothing to do with taxes. Rather, they were highly leveraged to a trend I proved dead wrong betting on: natural gas prices.

Rather than recover, gas has generally slid lower in 2007. The result has been a wave of trust distribution cuts and the virtual shutdown of gas production through vast swaths of western Canada.

I remain a believer in gas’s ultimate recovery. We’ve already seen a bounce off the lows in the past few months, as liquid natural gas imports have eased and the weather has become a little more volatile. And odds are great last year’s losers will be among our biggest winners in the next 12 months.

As for the rest of the Portfolio, several picks have been massive winners in Canadian dollar terms during the past year, particularly Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF), Energy Savings Income Trust (SIF.UN, ESIUF), Pembina Pipeline Income Fund (PIF.UN, PMBIF) and Vermilion Energy Trust (VET.UN, VETMF). But the steep rise in the Canadian dollar has been the critical factor in the performance of most.

Every jump in the loonie increases the US dollar value of trusts’ distributions and share prices by an equal amount. This year’s gains have basically translated into 20 percent-plus dividend increases and capital gains. That’s made substantial winners out of several trusts that actually ran in place or even lost ground in Canadian dollars.

In my view, the loonie will stay strong as long as oil does. And although today’s rise in black gold toward $100 a barrel may pause in the near future, there’s no 1970s-caliber conservation, switch to alternatives or conventional reserve discoveries that would indicate an end to the long-run bull market.

As a result, the Canadian dollar is likely to go higher still versus the US dollar before the trend finally reverses. In my view, any currency-related gains should be considered merely a bonus for buying and holding growing and undervalued businesses. We can’t count on strength in the loonie any more than we can a high-premium takeover of one of our trust holdings—or the government in Ottawa coming to its senses and reversing its 2011 taxation plans.

Rather, we’ve got to keep doing what we’ve been doing for the past year. That’s buying trusts backed by healthy, growing businesses when they’re cheap and patiently holding until the market finally figures out they’re worth a lot more than their prices now.

If we do get lucky and see a takeover, Canadian dollar gains or a favorable tax change, we’ll get a windfall next year. The point is we don’t have to in order to score big returns from top-quality trusts. Our picks just have to keep performing.

As for the tax issue, the fight goes on. As my colleague David Dittman and I have pointed out in our weekly Maple Leaf Memo, it’s still possible the Conservatives will lose the next election, though less likely than ever they’ll change their mind on 2011 taxation. Meanwhile, the legal prospects of a recent lawsuit by a Chicago couple under North American Free Trade Agreement (NAFTA) rules to overturn trust taxation are highly speculative.

No matter how either of these policy matters are resolved, however, we’re going to eventually see high-quality Canadian income trusts move to fair valuations at much higher levels. Coupled with dividends—still the highest in the world by far—that adds up to some pretty hefty returns. That’s reason enough to keep buying and holding these first-rate businesses.

Portfolio Action

I’m making two changes to the Canadian Edge Portfolios this month. First, I’m moving TimberWest Forest Corp (TWF.UN, TWTUF) from the Conservative Portfolio to the Aggressive Portfolio. The trust remains asset-rich as ever. But with global timber market conditions weakening and production off this year because of a now-settled labor strike, there’s too great a shortfall between cash flow and the distribution to avoid substantial dividend risk. 

My other move is to add battered TransForce Income Fund (TIF.UN, TIFUF) back to the Aggressive Portfolio, as a high-income comeback bet. The rest of this section reviews developments at other recommendations, including the recent disappointing results at Boralex Power Income Fund (BPT.UN, BLXJF) and robust earnings at Bell Aliant Regional Communications Income Fund, RioCan REIT (REI.UN, RIOCF) and Vermilion Energy Trust.

High Yields of the Month

This month my focus is on taking a little more risk for the prospect of bigger rewards by buying selected higher-yielding trusts. Both High Yields of the Month are Aggressive Portfolio members: Penn West Energy Trust (PWT.UN, NYSE: PWE) and TransForce Income Fund. Both are safe enough for the most conservative investors, provided they’re held within diversified, quality-first portfolios.

How They Rate

There are four new entries to trust coverage this month and two deletions. Off the list this month are recently acquired REIT Legacy Holdings and Sound Energy. On the list is income trust Cineplex Galaxy (CGX.UN, CPXGF) and three stapled shares: Keystone North America Trust (KNA.UN, KYSNF), Medical Facilities Corp (DR.UN, MFCIF) and New Flier Industries (NFI.UN, NFYIF).

Other changes include the following: Closed-end mutual fund Alberta Focused Income Fund (AFZ.UN, ABFCF) has been acquired by ACTIVEnergy (AEU.UN, ATVYF) for a slight premium. The ratio is 0.78214715 ACTIVEnergy shares per Alberta Focused share. I’m now covering ACTIVEnergy in How They Rate.

The Royal LePage Franchise Services Fund (RSF.UN, RYPGF)—a frequent buy recommendation—has changed its name to reflect its relationship with 25 percent owner conglomerate Brookfield Asset Management. The new name is Brookfield Real Estate Services Fund (BRE.UN, BREUF) and is now covered in How They Rate under that name as a buy up to USD14.

Finally, Oceanex Income Fund (OAX.UN, OCNXF) has now received unitholder approval for its takeover by a group of private capital investors for CAD19 per share in cash. It will be deleted from How They Rate beginning with the December issue. Ditto IPC REIT (IUR.UN, IPCUF), which has approved its takeunder with the expiration of its “go shop” option.

Here are advice changes. See the How They Rate or the Portfolio tables for changes in buy targets. Price and yield information is updated every 15 minutes on both tables.

• Canfor Pulp Income Fund (CFX.UN)—Hold to buy @13. The fund trimmed its distribution in the wake of the tumbling US dollar and was battered for it. But it’s now cheap and still boasts a solid business.
• Canetic Resources (CNE.UN, NYSE: CNE)—Buy @15 to hold. The merger with Penn West is a major plus. But now trading in line with takeover value, the trust is a hold until it gets done.
• Cinram International Income Fund (CRW.UN, CWSRF)—Hold to sell. The drop in the US dollar has pounded cash flow, and management is suspending its distribution indefinitely.
• Connors Brothers Income Fund (CBF.UN, CBICF)—Hold to sell. My brief upgrade to hold now looks premature, given the drop in the US dollar and its impact on cash flow. On the plus side, botulism legal risk appears to have fallen.
• PrimeWest Energy Trust (PWI.UN, NYSE: PWI)—Hold to sell. The US dollar value of the trust has soared on currency gains by the Canadian dollar, handing us an unexpected bonus. Take it.
• Priszm Income Fund (QSR.UN, PSZMF)—Sell to buy @6.50. The bottom has fallen out of the fast-food franchiser’s share price as it’s finally been forced to gut distributions. The good news is virtually all of the reduction will be restored in early 2008 and the business is already in turnaround mode, while the shares sell for just 84 percent of book value and 21 percent of annual sales.

Feature Article

A big yield is almost always a sign of high risks. But if a trust’s management navigates the danger, investors can realize hefty cash flow and big capital gains. The Feature Article looks at a handful of trusts yielding upward of 13 percent that presents an outstanding profit potential with limited risk.

There’s still some danger to their dividends. But they’re suitable for all investors within diversified, quality-focused portfolios.

Canadian Currents

We’re also increasing our coverage of high-yielding corporations in Canada. Here’s an update on our prior recommendations, along with a list of others we’ll be covering. Our new additions include a miner with international exposure and a major North American communications company.

Tips on Trusts

This section features short bits on a wide range of topics. For more evergreen and tutorial items, see the Subscribers Guide “Subscriber Tips” section.

Dividend Watch List—For the first time in many months, the brunt of distribution cuts didn’t fall on natural gas-focused energy producers. Rather, it was the 20 percent decline in the US dollar that took the most severe toll, with Canfor Pulp Income Fund, Cinram International Income Fund and Priszm Income Fund (QSR.UN, PSZMF) all cutting distributions.

The only other reduction was a gas-focused producer trust, Fairborne Energy Trust (FEL.UN, FELNF), which announced it as part of a plan to convert from an income trust to a corporation. See the table in this section for the comprehensive list of endangered dividends.

Buy the Business—We’re beefing up our coverage of stapled shares and other high-yielding Canadian trust equivalents. Not all are created equal, however, so let the buyer beware. Also note that Canadian limited partnerships aren’t exempt from 2011 taxation, have no real yield advantage over trusts and are, at best, difficult to buy as well.

The Word on Royalties—Alberta is raising royalty rates on producers as expected. What’s less appreciated is that oil and gas producer trusts came out generally well. We look at the particulars of the new royalty rules, which take into account reserve grades and energy prices. And, contrary to early reports, these rules definitely won’t shut down the energy patch.

Bay Street Beat—How the Canadian analyst community views trusts, and how to use that information.

More Information

The following is a regular repeat from prior issues.

Use our live quote feed on the How They Rate Table for US dollar prices of trusts intra-day. For other information, go directly to a trust’s website by clicking on its name in the table. Clicking on the Toronto symbol (suffix “.UN”) will take you to the web site of our Canadian partner Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8) http://www.adviceforinvestors.com/, which has price charts and access to press trust releases. For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site for a range of information on income and royalty trusts. The Web site http://www.sedar.com/ is an online library of documents filed by trusts with the Canadian equivalent of our Securities and Exchange Commission. The Toronto Globe & Mail features the “Globe Investor” section with all the latest news on trusts. Dominion Bond Rating Service is the pre-eminent credit rater for trusts. The Bank of Canada Web site features a handy currency converter for Canadian dollars and US dollars into 50 other currencies around the world, and it’s a great source of free information on the Canadian economy.

Roger Conrad
Editor, Canadian Edge