What to Buy
Not surprising, the question I get most often from readers—both longtime subscribers and newcomers—is what to buy now. Below, I look at the Portfolio picks with the best combination of growth, business reliability and yield right now. If you already have a portfolio of trusts, use them to augment your holdings. If you’re just getting started in this sector, they’re a great base to build on.
This week, Conservative Portfolio holding Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) boosted its distribution another 2.8 percent. That brought total distribution increases over the past year to 5.2 percent. Management also issued a very bullish projection for 2008 distributable cash flow of CAD720 million to CAD740 million, pointing the way to future increases.
Bell also announced its fourth quarter and full-year 2008 results, which were pretty much in line with prior quarters as well as expectations. Revenue rose 2.6 percent for the quarter because a 17.1 percent boost in Internet users offset slight erosion in basic local and long-distance customers. Overall Internet revenue surged 7.7 percent, while local and long-distance sales dipped 2.3 percent and 1.7 percent, respectively.
Bell’s earnings pattern mirrors that of US rural telecoms, with two exceptions. First, its local line loss rates are slower because it faces basically no competition throughout much of its territory. Second, it’s now actually winning back lost business because regulatory restrictions have been dropped.
The trust’s ace in the hole is its construction of a fiber-to-the-node network over the past year. Expenses peaked in 2007, resulting in a 9.3 percent dip in distributable cash flow (DCF). Now with most of the work completed, capital spending is slated to drop and DCF will rise commensurately. Meanwhile, the fiber network will reduce costs and increase the company’s capability to offer new services, which should boost revenue.
Like US rural telecoms, Bell is acquiring smaller systems. Earlier this week, it completed the takeover of Kenora Municipal Telephone System in a CAD27 million deal, adding another sizeable base of customers in an area where the trust already has a big presence. That offers considerable opportunities for upselling and efficiencies through scale.
In the US, rural telecoms sold off heavily in January on worries that a slowing US economy would crater sales and threaten distributions. Bell’s fourth quarter results, distribution growth and strong 2008 guidance are a crystal clear sign that’s not happening to its operations. That’s the best possible sign it will weather whatever happens in the economy. Yielding 10 percent-plus and selling for just 84 percent of book value, Bell Aliant Regional Communications Income Fund is my favorite Conservative Portfolio pick and a buy all the way up to 33.
Oil, Gas and the Loonie
With all of its operations in Canada, Bell Aliant’s cash flows aren’t affected by strength in the Canadian dollar. Meanwhile, a rising loonie boosts the US dollar value of both its distribution and share price.
As I point out in the Feature Article, the Bank of Canada has become concerned about the steep rise in the loonie and looks likely to try to control spikes. The good news is its primary method will be cutting interest rates. That has the effect of sparking up the economy and, by extension, is bullish for the stock market and Canadian trusts as well. Moreover, the strong loonie limits inflationary consequences of cutting rates.
The source of the loonie’s strength is the long-term bull market in commodities—oil in particular. At the moment, investors are worried a US recession could slow global oil demand and for good reason. A real US recession has historically sent the price of black gold plunging.
I remain convinced a drop into the USD70s is certainly be possible this year. In the long term, however, oil will remain in a bull market until we see a lot more of what ended that last bull market back in the 1970s: permanent demand destruction through widespread adoption of gas-saving automobiles, not only in the US but around the world and particularly in developing nations like China. And it also means the development of new economic supplies, as the opening of the North Sea was to the ’70s.
Any drop in energy demand and energy prices because of a recession has historically been short-lived, precisely because the demand destruction is temporary. In fact, it prolongs the long-term bull market by discouraging real conservation, alternatives and new exploration.
The decline may be painful for energy investors while it lasts. But when it inevitably passes, energy demand will resume with a vengeance, prices will spike to new highs, and the Canadian dollar will push upward again.
All in all, I expect the loonie to be a net positive for most trusts’ returns in 2008. And we should also avoid the spikes that have pressured many trusts’ businesses, such as energy producer trusts.
Many investors have been confused about why oil and gas producer trusts haven’t followed oil prices higher. The reason is threefold.
First, energy stocks in general have lagged the rise in the crude oil. Although the raw commodity reflects real-time supply and demand issues, energy stocks reflect investor expectations for future prices, which have routinely lagged the energy bull market since it began. As recession fears have risen, so have fears of falling energy prices. As a result, energy producer stocks from Super Oils to juniors to limited partnerships and Canadian income trusts are now trading as though energy prices have already fallen sharply.
Second, the vast majority of trusts produce natural gas as well as oil. In stark contrast to oil, gas prices have been exceedingly soft, with the weakness dating back to the very mild winter of 2005-06 following hurricanes Katrina and Rita. Large, diversified trusts have offset weakness in gas with strength in oil. But smaller trusts and gas-focused fare have been repeatedly forced into making dividend cuts, and more than a few have entered death spirals.
Unfortunately, many investors in trusts—including more than a few who run real money—don’t display a lot of sophistication differentiating between trusts. As a result, even the strongest trusts have been prone to sell off when a weakling slashes its distribution.
The third factor holding back oil and gas producer trusts is, ironically, the strength in the Canadian dollar. Oil is priced in US dollars on global markets. As a result, rising oil prices can be at least partly offset by a corresponding boost in the Canadian dollar.
As noted above, the loonie’s strength is likely to be an issue for oil production profits as long as this bull market lasts. With the BOC on the warpath to control its rise, however, it should be less so for the rest of 2008.
As for oil prices, it would take a drop well less than USD70 a barrel to really take a bite out of Canadian oil producer trusts’ profits. That’s because, as I pointed out in the December issue, strong trusts have been covering their distributions handily by selling oil at USD70 and lower.
On the whole, oil and gas trusts appear to be discounting oil in the USD70-to-USD75-per-barrel range, and natural gas prices of appproximately USD6.50 per million cubic feet. That’s well below current forward market prices for 2008, as well as prices likely realized in the fourth quarter. As a result, energy trusts should see rising valuations in 2008 even if energy prices stay relatively flat.
Moreover, as Canadian Currents points out, gas supplies have tightened this winter for the first time in several years. One reason is the weather, which has triggered record gas withdrawals from storage in recent weeks. Another is the massive idling of Canadian rigs drilling for gas, which Canada’s National Energy Board projects will cut deliverability of Canadian gas by 15 percent over the next two years. Also, gas prices have surged in Europe this year, sharply curtailing imports of liquid natural gas to the US.
More important to the long term is that natural gas use is again on the rise in the power industry. Switching to gas from coal is the fastest way for utilities to slash carbon-dioxide (CO2) emissions blamed for global warming. And now that the Bush administration has pulled funding for FutureGen—a public/private partnership to develop commercially available CO2 sequestration—utilities are turning to gas in earnest. Several major plants are in the works and, unlike nuclear plants, will require only a couple years to come on stream.
Switching to gas will ultimately cost the consumer more. But carbon regulation is coming, probably as soon as 2009. And until real technology is developed to extract the carbon from coal, utilities will have little choice but to move to gas in earnest. That means more demand, even if the weather stays abnormally mild for years or the US economy slides into recession.
It’s still too early to forecast a rally in natural gas for 2008. But this improvement in fundamentals—despite the slowing growth in the US—is a pretty good indication of strength in prices. Even long-lagging AECO natural gas prices—where many of the trusts benchmark their output—were up 20 percent year-over-year in late January.
We won’t have full results for Canadian oil and gas producer trusts for some weeks. But the strong showing by Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF) indicates it should be a solid quarter for oil production. Meanwhile, these promising signs for gas point to solid results for its producers as well, at least for the likes of the strongest trusts such as ARC Energy Trust (TSX: AET-U, OTC: AETUF), Enerplus Resources (NYSE: ERF, TSX: ERF-U) and Penn West Energy Trust (NYSE: PWE, TSX: PWT-U).
This trio isn’t pricing in anything resembling an improvement in natural gas prices. Rather, they sell off every time the market seems to worry about the US economy and, by extension, oil prices.
I expect all three to report a solid fourth quarter in coming weeks. More important, however, they’ve put the pieces in place for more robust and sustainable growth. ARC, for example, announced two new major natural gas discoveries last month in British Columbia. The trust has ramped up its capital budget by CAD40 million on the new fields, where production is expected to begin flowing in 2009. ARC has also been active adding raw land in the region for further development.
ARC also has partnered with the Alberta Research Council on a pilot project to boost oil and gas production by injecting CO2 into wells. The result would be increased production and a reduction of CO2 emissions, a double play for ARC and its partners.
The best thing about ARC is it always puts the long-term sustainability of its business first. Not surprising, it’s financing these projects with internal cash flow, while holding debt and new equity issues to a minimum. ARC Energy Trust is a superb buy for conservative investors for income and a play on energy.
Enerplus is on track to complete its merger with Focus Energy Trust (TSX: FET-U, OTC: FETUF) Feb. 13. That deal looks even better in light of Focus’ development of another find near its prolific Tommy Lakes field.
Like ARC, Enerplus’ focus is on long-run sustainability, and it’s made several long-term bets to keep output on track, including a major investment in the Baaken region and in the oil sands. Both should pay off richly over the next few years, even as the Focus deal gives output a boost this year. Enerplus Resources is a strong buy up to USD50.
Last but not least, Penn West has now completed the takeovers of the former Canetic Resources and Vault Energy Trust to form the largest conventional oil and gas producer trust. Both deals were carried off at virtually no premium and with little cash outlay, holding debt to manageable levels and ensuring the purchases will be accretive to 2008 earnings.
Penn West is the only trust outside Canadian Oil Sands to have a working interest in a producing oil sands property. It basically came out neutral on the Alberta royalties increase and continues to ramp up output. Its success didn’t make the rather bearish article on oil sands in the Feb. 5 Wall Street Journal. But it’s another reason Penn West Energy Trust is attractive all the way up to USD38 for investors of all stripes, and I can’t think of anything this solid yielding close to 15 percent.
If you can only buy three energy trusts, these are your best bets. But I also remain a major fan of our other oil and gas producer plays.
Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) has its footprint now on four continents, providing unmatched diversification by market and thereby distribution safety. The yield is lower than for other trusts, But it was increased 12 percent recently, and more boosts are on tap. Buy Vermilion Energy Trust up to USD40.
Provident Energy Trust (NYSE: PVX, TSX: PVE-U) is perpetually aggressive when it comes to maximizing shareholder value. The trust surprised Wall Street this week by announcing a strategic review that could result in the sale or monetization of both its general partner and limited partner interest in the BreitBurn Energy Partners LP (NSDQ: BBEP), as well as the sale of its other US assets.
I expected the trust to continue to invest heavily in the US in order to take advantage of growth opportunities and maximize potential 2011 tax dodges. This is a clear sign, however, that management intends to be nimble in this challenging environment. The strategic review also includes exploration of strategy to deal with 2011 taxation issues. A major announcement should give these shares a near-term lift. That’s another good reason to buy Provident Energy Trust up to USD14 if you haven’t already.
For those who want to make a big bet on natural gas now, my advice is to take it slow. But I do have three great candidates for purchase now: Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U), Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) and Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF).
Of the trio, Peyto is the most conservative, with its extremely low costs, proved reserve life as long as ExxonMobil’s (14 years-plus) and strong balance sheet. Paramount is the most aggressive at 100 percent gas production, with a relatively short reserve life and high debt. Advantage is perhaps the best bet for a merger, though management has professed its desire to be an acquirer rather than the other way round.
All three should post improved fourth quarter 2007 results, with the good fortune extending into 2008 on the firming up of the natural gas market. And all appear to be able to sustain distributions, even if prices soften somewhat. Paramount, for example, is expecting a payout ratio of around 50 percent based on very conservative forecasts for gas prices.
Peyto shares have held up very well over the past year, even with weak natural gas prices, but still yields more than 10 percent. Advantage shares have fared less well—largely because of a distribution cut announced late last year—and now yield well more than 15 percent and sell for just 94 percent of book value. Higher-than-average debt may be a deterrent to some would-be acquirers, but that will change as gas prices continue to bounce back. Finally, Paramount has been hammered over the past year, but the shares appear to have at least made some kind of bottom.
These trusts stand out in stark contrast to most gas-focused producer trusts in that none are in any danger of entering a death spiral. It’s likely to take more patience to ride their future recovery. But if gas prices keep coming back, the gains will be staggering. Advantage Energy Income Fund (USD12), Paramount Energy Trust (USD10) and Peyto Energy Trust (USD20) are strong buys but only for patient and aggressive investors.
Other Bargains
Outside of energy—which is constantly impacted by external factors, namely energy prices—the biggest boosts in trusts’ cash flow and profits will come from successful acquisitions. Both High Yields of the Month have been extremely successful on that score in recent years and promise to continue their strength in 2008 and beyond: Trinidad Energy Services Income Trust (TSX: TDG-U, OTC: TDGNF) and Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF).
The graph “Growth By Acquisitions” tracks performance of a couple more favorites that have pursued similar growth, to the immense benefit of shareholders. AltaGas Income Fund (TSX: ALA-U, OTC: ATGFF) completed its biggest purchase to date last month, boosting its asset base by 65 percent with the addition of Taylor Natural Gas Liquids LP.
Buying Taylor adds long-life midstream energy assets that overlap with AltaGas’ existing base, providing numerous opportunities for savings and synergies. And Taylor also boosts AltaGas’ efforts in renewable energy by adding a series of hydroelectric assets.
The biggest benefits of the purchase will be realized in the long haul with added scale and opportunity for growth in western Canada. But there’s also a near-term kicker: The deal is expected to boost AltaGas’ cash flow in 2008 and earnings per share in 2009. With no direct exposure to US economic weakness or the strong Canadian dollar, AltaGas Income Fund is a buy up to USD28.
Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) is aggressively adding to two cash-generating business lines with acquisitions. Last month, the trust’s 45 percent-owned Leisureworld unit completed the purchase of seven “Class C” senior care facilities with 1,127 total beds and a superior 95 percent occupancy rate. The deal is expected to immediately boost Macquarie’s income stream, supporting the recent distribution boost.
Buy Macquarie Power & Infrastructure Income Fund—boasting one of the safest double-digit yields around—up to USD12.
Artis REIT (TSX: AX-U, OTC: ARESF) is another Conservative Portfolio pick that continues to grow rich with timely acquisitions. The REIT inked another major leasing agreement last month, locking up 3 percent of its total space with a five-year deal. The REIT has now renewed 58 percent of its portfolio under similar long-term leases at an astronomical average increase in base rent of 79 percent. That’s expected to add at least CAD3 million to cash flow in 2008, and there’s a lot more growth ahead for the trust’s western Canada portfolio.
Management’s priority remains taking advantage of growth opportunities by plowing cash into the business, rather than boosting distributions. The current yield is above average and increases are only a matter of time. Artis REIT is a buy up to USD18.
Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) shares have been hit because of concerns about the Canadian economy in the face of a US recession. As the Feature Article details, Canada’s property market remains strong.
But this REIT’s real strength has always been maintaining a conservative portfolio, a point underscored by its successful sale of several eastern Canadian properties last month to finance ongoing diversification into western Canada.as well as more strategic purchases in stronger eastern areas like Toronto. With far less risk and a much higher yield than US residential REITs, Canadian Apartment Properties REIT remains a bargain up to USD20.
To date, all of my Canadian Edge Portfolio trusts have been able to roll over their credit agreements with ease. Last month, Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF) extended and widened its credit line by adding a fourth bank. That promises to be a major plus for growth going forward and is another reason Algonquin Power Income Fund shares rate a buy up to USD9.50.
Other trusts like Newalta Income Fund (TSX: NAL-U, OTC: NALUF)—which has been challenged by a toughening environment in the energy services business for its clean up services—have been able to maintain aggressive capital spending plans thanks to solid credit. Newalta Income Fund is also a buy up to USD25.
Two strongly growing trusts, however, appear to have been singled out by investors concerned about potential exposure to a slowing economy: GMP Capital Trust (TSX: GMP-U, OTC: GMCPF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF). Both trusts now arguably are pricing in a sharp slowdown in recent growth rates, Yellow for its exposure to advertising and GMP for its reliance on financial markets.
Only earnings will reveal if these fears are well founded or not. To date, neither trust has shown much sign of weakening, In fact, Yellow Pages has continued to migrate its business to the Internet, adding a video option and firming up its alliance with MicroSoft Canada. Even if the pair does post solid fourth quarter results, as I expect, there’s no assurance their shares will rebound swiftly from the past month’s slide; investors may simply transfer their worries to future quarters.
Ultimately, if their businesses stay strong, we’re going to see huge returns from here. That’s a good reason to hang onto them and for new investors to buy Yellow Pages Income Fund up to USD16 and GMP Capital Trust up to USD25.
As longtime readers know, I’m a firm believer that a well-chosen portfolio will always beat a mutual fund. That goes double for underappreciated areas such as Canadian income trusts. But some closed-end funds that hold portfolios of trusts are worth a look.
The two I feature in the Portfolio are EnerVest Diversified Income Fund (TSX: EIT-U, OTC: EVDVF) and Select 50 S-1 Income Trust (TSX: SON-U, OTC: SFYIF). As a value bet, it’s hard to beat EnerVest, with its massive 17 percent-plus discount to net asset value and monster 16 percent yield. Throw in the fund’s generally steady track record and reasonably steady net asset value throughout trusts’ recent stress tests, and you’ve got a good argument for those who don’t own it to buy EnerVest Diversified Income Fund up to USD7.
Unfortunately, EnerVest management is still focused on accumulating assets and has thus far refused to buy back shares to narrow its discount. As long as that’s the case, the discount will remain wide, and barring a real breakout move by the Toronto Stock Exchange Trust Composite, the shares won’t move appreciably higher. That makes the Select 50 S-1 Income Trust the better choice for conservative investors up to USD13. Note the fund paid a special cash distribution of 79 cents Canadian a share Jan. 15.
Finally, for those who want to mirror the Conservative Portfolio philosophy in a fund—i.e., minimizing exposure to cyclical industries like energy and focusing on good businesses paying high yields—Series S-1 Income Fund (TSX: SRC-U, OTC: SRIUF) is now my top choice, as well as a new Portfolio recommendation.
The fund trades at a modest discount to net asset value of roughly 7 percent but buys back shares whenever that discount is above 5 percent. Dividends were raised 11 percent last year as the fund strongly outperformed its competition with a total return of nearly 30 percent in US dollar terms.
The fund’s current portfolio is just 17 percent oil and gas, with the balance in mostly stable fare such as power and pipeline trusts, recession-resistant business trusts and REITs. Series S-1 Income Fund is a buy up to USD10.