Building on Growth
That’s a major plus for the best of the biggest, particularly High Yield of the Month RioCan REIT (TSX: REI-U, OTC: RIOCF). And the change gives us reason to hope for more moderation in the law in the next three years, even if the Conservatives do hang onto power.
As we enter 2008, the risk of tighter credit conditions and a US recession make for a tough investing environment. Last month, no fewer than eight trusts cut distributions, with three eliminating them entirely.
Weakness in the Canadian natural gas business continues to punish producers and service trusts alike. And we’re still seeing the dissolution of ill-constructed trusts.
There are also very clear signs, however, that well-run trusts are going to keep building on growth in 2008. First off, 42 have now increased distributions at least once since Halloween 2006. That’s the best affirmation possible that they intend to keep paying generous distributions well after 2011, when their tax status is slated to change.
Moreover, the boosts come at a time of unprecedented business stresses for trusts, including tighter credit conditions, restrictions on new share issues, weaker North American growth and depressed gas prices. That’s solid evidence they’re running businesses that are built to last and capable of making big payouts well past 2011.
Despite a very turbulent November and December, the benchmark S&P Toronto Stock Exchange Trust Composite Index is still well above the lows it set in late 2006. It’s also well below the highs of mid-2007, when trusts as a group briefly moved above pre-Halloween massacre levels.
That flat performance overall, however, masked huge divergences among individual trusts. As the Portfolio section points out, Canadian Edge was generally able to stick with good businesses and eschew weaker ones in 2007. The average total return was 11.4 percent, though I had some mishaps as well, particularly a premature bet on a recovery in natural gas prices and drilling activity.
Turbulent conditions mean massive divergences should still be the rule in 2008. Separating the wheat from the chaff will again be the key to making money. We may indeed get lucky on the trust taxation front.
Some trusts will benefit from takeovers, and a bull market in oil is likely to keep the Canadian dollar on solid footing. The bottom line, though, is our bottom lines are going to depend on identifying high-quality businesses and sticking with them.
Good businesses come in all shapes and sizes. From a dividend safety perspective, your best bets are always in the most reliable sectors. That basically means the Conservative Portfolio.
Last year, the Conservative Portfolio far outshone the Aggressive Portfolio, which focuses primarily on more volatile sectors like energy. In fact, all of my significant losers were Aggressive Portfolio holdings, and all the biggest winners were on the Conservative side.
From a portfolio performance standpoint, however, you’re always better off holding the best-quality plays from a wide range of sectors. That’s because, in the long term, inflation risk is as important as credit risk for income investing success.
As long as credit remains the larger concern, the Conservative Portfolio will continue to outperform. Sometime later this year, however, investors are likely to lose their fear of recession. And at that point, the Aggressive Portfolio holdings will be the stars. In fact, some of last year’s biggest losers are in the best position to become our greatest winners.
Diversification is the only certain way to enjoy the comeback of more aggressive trusts in 2008 while keeping whole in the meantime. Doing it successfully is how we’ll make our money this year, even if we don’t catch a real break with taxes, the Canadian dollar or takeovers.
Portfolio Action
There are no additions, subtractions or otherwise changes to the Canadian Edge portfolios this month. All of the Portfolio recommendations as of this writing are in a buying range.
Note that I don’t recommend doubling down or overloading on any position, no matter how attractive it looks on paper. You get too emotionally involved in your investments to act rationally. Rather, strive for balance among the Portfolio positions.
The most risk averse will want to focus on the Conservative Portfolio. The more aggressive will want to mix in more Aggressive Portfolio selections, the majority of which are tied to volatile energy markets.
High Yield of the Month
The January Conservative Portfolio High Yield of the Month is RioCan REIT, a major potential beneficiary of recent Canadian government loosening of the prospective tax rules for 2011. The Aggressive Portfolio High Yield of the Month is Provident Energy Trust (NYSE: PVX, TSX: PVE-U), which is cheaper than it’s been in some time because of investor selling in the wake of several recent acquisitions.
How They Rate
This issue’s table includes updated safety ratings initiated last month. The only deletion this month is CCS Income Trust, which has been taken over in a management buyout for CAD46 per share in cash.
Replacing it is global loyalty management company Aeroplan Income Fund (TSX: AER-U, OTC: AOPIF). Here are this month’s advice changes. For changes in buy targets, see the How They Rate Table.
- ActiveEnergy Income Fund (TSX: AEU-U, OTC: ATVYF)—Hold to buy @10. The closed-end fund has successfully absorbed its merger with the former Alberta Focused Fund and is a solid play on this growing region, selling at a 5.7 percent discount to net asset value.
- AG Growth Fund (TSX: AFN-U, OTC: AGGRF)—Hold to buy @34. It’s full steam ahead for the North American agriculture business, with mandates for massive ethanol production growth now enshrined in US law. AG has been growing rapidly, and the new law will go a long way toward keeping that momentum going.
- Morguard REIT (TSX: MRT-U, OTC: MGRUF)—Hold to buy @13. Armed with a solid portfolio and conservative finances, this REIT should enjoy increased buyer interest this year. The 7 percent-plus yield is generous as well.
- Precision Drilling (NYSE: PDS, TSX: PD-U)—Sell to buy @16. Tax-selling season is over, and Precision is again back on my buy list for patient, risk-tolerant investors. The trust’s new capital spending plan is aggressive and will spur a turnaround by late 2008 to early 2009, even if natural gas prices remain weak. Downside also looks limited from here; but Precision still depends on a depressed market. Therefore, its shares will continue to be volatile.
- PRT Forest Regeneration Fund (TSX: PRT-U, OTC: PFSRF)—Sell to hold. The trust has now cut its distribution back to a more sustainable level, based on a conservative market forecast for 2008. With the shares now selling for just 91 percent of book value, it’s again fairly priced for its risks, though recovery almost certainly won’t happen until the US economy reaches a true bottom.
- SFK Pulp (TSX: SFK-U, OTC: SFKUF)—Sell to hold. The St. Felicien pulp mill is now back on line, and market conditions in the pulp industry are improving. Management is keeping a tight rein on cash flow, with debt reduction and reserve replenishment the priority for now. But assuming the plant stays on line and conditions don’t worsen, a distribution increase is likely by the second half of 2008.
- Tree Island Wire Income Fund (TSX: TIL-U, OTC: TWIRF)—Hold to sell. Conditions in the US housing industry, the trust’s key market, aren’t getting better any time soon. Until they do, Tree Island will be swimming upstream against an accelerating current.
Feature Article
Merger activity in the trust sector was fast and furious in the first half of 2007. Although it slowed a bit in the second half, there’s every indication we’ll see many more deals in 2008 and beyond, both involving private capital and between the trusts themselves.
Not every deal will throw off a high premium to shareholders of the acquired trusts. Most, however, will confer substantial long-term value.
The key is to own shares of trusts you’d want to hold even if there’s no deal. Top candidates for deals in 2008 include: Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U), Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF), AltaGas Income Fund (TSX: ALA-U, OTC: ATGFF), Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), Crescent Point Energy Trust (TSX: CPG-U, OTC: CPGCF), Jazz Airline Income Fund (TSX: JAZ-U, OTC: JAZFF), Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF), Penn West Energy Trust (NYSE: PWE, TSX: PWT-U), Progress Energy Trust (TSX: PGX-U, OTC: PGXFF) and TransForce Income Fund (TSX: TIF-U, OTC: TIFUF).
Canadian Currents
This month, our focus is Canada’s tar sands. Contributing Editor Elliott Gue—editor of The Energy Strategist—updates the latest on the region’s potential. This is shared by several trusts, including Enerplus Resources (NYSE: ERF, TSX: ERF-U) and Penn West Energy Trust.
Tips on Trusts
This section is basically short takes on a range of topics. This month’s items are in larger bites. Below, I list the main points of each segment in brief. For other items, see the Subscribers Guide “Subscriber Tips” section.
Dividend Watch List—Another eight trusts cut their distributions last month. Three are oil and gas producers, two are energy services providers, one is a coal miner, one is a diversified holding company, and the last is a grower of seedlings.
Flaherty Rejects SWF—Finance Minister Jim Flaherty is opposed to a national fund to buy and manage assets. But that won’t stop other sovereign wealth funds from buying Canadian assets.
Running to Stand Still—The Conservative Party is still leading the national horse race but is further away than ever from forming a majority government.
Bay Street Beat—The latest on how Canada’s version of Wall Street views income trusts, including several of our favorites.
More Information
The following is a regular repeat from prior issues.
Check out the Toronto Stock Exchange Web site for a range of information on income and royalty trusts. For questions and comments, drop us a line at canadianedge@kci-com.com. Clicking on a trust’s name in the How They Rate Table will take you directly to its Web site. Clicking on the Toronto symbol (suffix “.UN”) will take you to www.adviceforinvestors.com, the online information service of CE’s Canadian partner, Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8). The Web site 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