Two-thirds of the trusts in the Canadian Edge universe yield double digits or better. Three-quarters produce enough cash flow to cover their generous distributions by a comfortable margin. Thirty-seven trusts—or more than a third—have raised dividends at least once since Halloween 2006. And four out of every five sell for less than 1.5 times book value and/or a discount to annual sales.

Those are rare values, particularly here in late 2007, when recession-fearing investors have pushed more traditional income havens such as utility stocks to all-time highs. Equally scarce is the margin of safety offered by top-quality trusts backed by solid businesses, at a time when almost any economically sensitive investment is at risk of a blowup.

Perhaps the most surprising statistic about trusts now is—despite one of the more volatile markets in memory and almost unprecedented business challenges—most are actually up for the year. US investors’ profits have been fatter still because of a double-digit gain by the Canadian dollar.

I expect much more in the year ahead. For one thing, growing numbers of trusts are starting to give guidance about what we can expect for distributions in 2011 and beyond, assuming they wind up being taxed as corporations. Even the most affected are looking at prospective tax rates and dividend cuts far less than the 31.5 percent originally anticipated. And a surprising number—many of which populate the CE Conservative Portfolio—won’t have to cut at all.

More important, despite the volatile Canadian dollar, challenges accessing capital markets, weak natural gas prices and, finally, a contracting US economy and market panic, trusts backed by good businesses are still growing and raising distributions. Sooner or later, their shares will follow that growth higher, as they always have.

Waiting for that value to be recognized is probably the biggest challenge facing Canadian trust investors here in late 2007. The markets continue to react to the latest economic worries on an almost daily basis, and bad days hit trusts’ prices hard, regardless of whatever good news is reported on the business front.

Value will ultimately win out. But there may be more downside before it does.

One way we’ll see profits emerge more quickly is through takeovers. Investors seem to have forgotten that just a couple months ago Abu Dhabi’s TAQA offered a price for second-tier gas producer PrimeWest Energy Trust (PWI.UN, NYSE: PWI) that was 40 percent above its prior range.

Despite some initial sparks, regulatory approvals have been achieved, and the deal should be completed this month, with shareholders getting CAD27.25 a share in cash. High-premium takeovers of CCS Income Trust and Oceanex Income Fund were completed last month.

The upshot: Investors on both side of the border may still be deeply skeptical of trusts. But the smart money is more willing than ever to pay up for good businesses. That means potential windfall gains for those who do nothing more than buy and hold trusts we’d want to own anyway.

Portfolio Action

It’s time for a little year-end house cleaning in the Canadian Edge portfolios. I’m making four changes.

I’m recommending selling Aggressive Portfolio holdings Precision Drilling (PD.UN, NYSE: PDS) and TimberWest Forest Corp (TWF.UN, TWTUF). Ironically, I’m more worried about TimberWest, in which I have a large profit, than in Precision, where we have a big loss. We may look to buy both back when their prospects come in a bit clearer.

Third, I’m moving Boralex Power Income Fund (BPT.UN, BLXJF) to the Aggressive Portfolio to reflect its dividend risk.

Fourth, I’m adding High Yield of the Month GMP Capital Trust (GMP.UN, GMCPF) to the Conservative Portfolio. The rest of this section rounds up earnings for all 29 Portfolio trusts.

High Yields of the Month

Both of my High Yield of the Month candidates are rapidly growing their businesses. GMP Capital Trust is quickly building Canada’s most flexible and profitable investment banking franchise and is a sure bet to capitalize on the continued prosperity of the country’s natural resource sectors. Enerplus Resources (ERF.UN, NYSE: ERF) is a premier oil and gas producer that’s suddenly very cheap again after putting together a takeover offer for low-cost gas producer Focus Energy Trust (FET.UN, FETUF).

How They Rate

This month, I’ve added Colabor Income Fund (CLB.UN) to the How They Rate Table. Off the list is recently acquired Oceanex Income Fund, which has been purchased for CAD19 per share in cash. I’m also dropping IPC REIT (IUR.UN, IPCUF)—acquired for CAD9.75 per share last month—and Legacy Hotels REIT (LGY.UN, LEGYF), bought for CAD12.60 a share.

Note Alberta Focused Fund has been merged into ActivEnergy Income Fund (AEU.UN, ATVYF) at a rate of 0.78214715 shares per Alberta Focused share. It’s now covered under that name in the How They Rate Table. Also, the former Royal LePage Franchise Fund is now officially Brookfield Real Estate Services (BRE.UN, BREUF) and is tracked under that name in the How They Rate Table.

Note that the private capital takeover of CCS Income Trust has also been completed for CAD46 per share, and the trust will be dropped from coverage in January.

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

• A&W Revenue Royalties Income (AW.UN, AWRRF)—Hold to buy @14. Who cares if its distribution is taxed in the US as ordinary income? How many investments are there that yield nearly 10 percent and grow their distribution regularly in a stable business?
• Acadian Timber Income (ADN.UN, ATBUF)—Buy @12 to sell. Timber market conditions appear to be deteriorating quickly. We should be able to buy this well-managed trust back cheaply in coming months.
• Daylight Resources Trust (DAY.UN, DAYYF)—Sell to hold. Production gains and a ramp-up of oil output stabilized cash flow, although takeover prospects are still unexciting.
• Essential Energy Services Trust (ESN.UN, EEYUF)—Hold to sell. The dividend cut was inevitable, but it’s time to take a tax loss in this non-performer.
• Focus Energy Trust (FET.UN, FETUF)—Hold to buy @18. The distribution increase, the discount to takeover value and the prospect of being part of powerful Enerplus are good incentives to pick up shares.
• Fording Canadian Coal (FDG.UN, NYSE: FDG)—Buy @38 to sell. This one tacked on some big time gains in 2007. But management has now said flat out cashflow (and distributions) will fall again in 2008, unless coal prices can break out. Take the profit, and plan to get back in later when the US economy bottoms.
• Harvest Energy Trust (HTE.UN, NYSE: HTE)—Hold to buy @22. The trust has gone to deep value because of investor overreaction to the recent dividend cut. Refining is weak, but the price is very low.
• Mullen Group Income Fund (MTL.UN, MNTZF)—Hold to sell. Too much exposure to energy patch transportation has put the distribution in danger. If you want exposure to the battered trucking sector, stick to TransForce Income Fund (TIF.UN, TIFUF).
• Newport Partners Income (NPF.UN, NWPIF)—Hold to sell. How many quarters can a trust not cover its payout and still not cut its distribution? Time is running out on management to turn around cash flows here from this mishmash of businesses, and debt is rising steeply.
• Peak Energy Services Trust (PES.UN, PKGFF)—Buy @4 to sell. Bankruptcy is an extremely remote possibility. But tax-selling season is a good time to take the loss on one that hasn’t worked out so far.
• Precision Drilling (PD.UN, NYSE: PDS)—Buy @25 to sell. It’s time to take a tax loss, though this one’s recovery is only a matter of time.
• PrimeWest Energy Trust (PWI.UN, NYSE: PWI)—Sell to hold. The Abu Dhabi deal looks set, but the price has come off from takeover value of CAD27.25 per share.
• PRT Forest Regeneration Fund (PRT.UN, PFSRF)—Hold to sell. The trust’s shares were up sharply last month on takeover rumors. Unfortunately, the weak US dollar has pushed up the payout ratio to 100 percent—not a favorable combination.
• SFK Pulp Fund (SFK.UN, SFKUF)—Hold to sell. The latest dividend cut may mark the bottom if the trust can get its largest facility back on stream. Recovery, however, will take time, so now’s a good opportunity to book the loss.
• Somerset Entertainment Income (SOM.UN)—Hold to sell. Private capital firm Clarke is still increasing its stake. But these entertainment trusts just don’t seem to work on a high-dividend model.
• Sun Gro Horticulture (GRO.UN, SGHRF)—Hold to sell. Management’s move to expand markets in the US is a long-term plus. But third quarter results show what happens when a trust takes on a lot of debt to expand and then gets hit by a weaker US dollar.
• Swiss Water Decaffeinated Coffee Income Fund (SWS.UN, SWSSF)—Hold to sell. Competition and a weak US dollar are tough to overcome.
• TimberWest Forest Corp (TWF.UN, TWTUF)—Hold to sell. Unless very weak forestry conditions turn around soon, this trust will not earn its distribution for a while. A dividend cut would take its lofty price down in a hurry.
• Vault Energy Trust (VNT.UN, VNGFF)—Hold to sell. The board’s decision to delay the Penn West Energy Trust (PWT.UN, NYSE: PWE) merger vote to January is quizzical. Given the likelihood of bankruptcy if this deal fails, I don’t want to take a chance when I can own infinitely stronger Penn West itself.
• Wellco Energy Services (WLL.UN, WLLUF)—Hold to sell. This one has been a major loser this year, and recovery doesn’t look imminent. Take the tax loss.

Feature Article

Since mid-2006, Canadian income trusts have had to withstand a series of trials by fire, ranging from the volatile Canadian dollar and slumping natural gas prices to the decision to tax them as corporations beginning in 2011. Those that have survived and thrived as businesses have proven to be among the world’s sturdiest investments. But there are still trials ahead, ranging from the explosion of debt at some trusts in the midst of a global credit crunch to a potential waterfall drop in oil prices because of recession pressures. I look at these trouble spots and what to watch out for in the year ahead.

Canadian Currents

Canada is a literal treasure trove of natural resources, of which oil sands and conventional oil and gas are only a part. We survey the country’s bounty and highlight opportunities, some of which are being exploited by recommended trusts and the nontrusts we’ve been highlighting in our Tips on Trusts section.

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—Distribution cuts picked up steam again in November. There were few surprises, however, as reductions involved either the usual suspects or trusts that had been telegraphing such moves for some time. Highlighted this issue are distribution cuts at Canfor Pulp (CFX.UN), Essential Energy Services Trust (ESN.UN, EEYUF), Harvest Energy Trust (HTE.UN, NYSE: HTE), Primary Energy Recycling (PRI.UN, PYGYF), SFK Pulp Fund (SFK.UN, SKFUF) and Trilogy Energy Trust (TET.UN, TETUF). See the table in this section of the comprehensive list of endangered dividends.
DRIP…DRIP…DRIP—Not many Canadian income trusts open their dividend reinvestment plans to US investors. The reason is tough Securities and Exchange Commission (SEC) paperwork requirements that are expensive to deal with. There are exceptions, and we point them out.
Even More Northern Exposure—Here’s the latest of our continuing coverage of high-yielding corporations in Canada. We update our prior recommendations, along with some new finds.
The Movie Star—Here’s how the Canadian analyst community views one of our new How They Rate 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