A Year of Positives
As the Feature Article makes clear, the environment is challenging, with US economic health the major concern. And several of my favorite trusts took on water in January’s fear-soaked market, despite continuing to operate very strong, recession-resistant businesses.
Ironically, the pieces are rapidly fitting into place for a strong recovery by the latter half of 2008. First, the Bank of Canada (BOC)—that country’s equivalent of the US Federal Reserve—is cutting interest rates. That’s a big plus for the country’s growth, the health of its stock market and Canadian trusts’ share prices.
Further, without rate cuts, the Canadian dollar would likely shoot to the moon. And the BOC has a lot of flexibility, given Canada’s strong economy and low inflation. That’s a stark contrast with the US Fed, whose rate cuts continue to weaken the US dollar.
The second major positive for Canadian trusts in 2008 is differentiation. Before the stress tests of the past year, investors tended to view all trusts as cut from the same cloth. Today, strong trusts are increasingly distinguishing themselves from the weak as able to survive and thrive well past 2011. That will earn them higher valuations in coming months, even as the weakest trusts continue their death spirals.
The flurry of private capital takeovers of trusts has largely stalled in recent months because the global credit crisis has dried up sources of cheap money. But as Essential Energy Services Trust’s (TSX: ESN-U, OTC: EEYUF) high-premium takeover of smaller Builders Energy Services Trust (TSX: BET-U) last month demonstrates, the urge to merge among trusts is greater than ever.
This merger fever has being increasingly joined by shareholder activism. Hedge fund FrontFour, for example, won its first-ever activist fight last month, a proxy fight to replace three members of the board of Huntingdon REIT (TSX: HNT-U, OTC: HURSF). Its success may not lead to a full-scale takeover or even a rash of similar moves at other trusts. But it does serve notice to managements that trust unitholders will defend their interests, which should help raise values all around.
The fourth major positive is the apparent bending of the Canadian government on some of the taxation issues affecting trusts. Last month, I commented on the relaxation of rules governing investment by REITs, which will now ensure virtually all of the industry qualifies for favorable tax pass-throughs in 2011 and beyond. Now the Conservative government has announced a reduction in the corporate tax rate to 15 percent in 2012 and a cut in the future tax rate for income trusts to 28 percent from the previously advertised 31.5 percent.
That’s still a ways higher than the current rate of zero. But with 2011 still almost three years away, it’s increasingly likely we’ll see more favorable adjustments, even as individual trusts find ways to bring their 2011 rates closer to the average 6 to 7 percent rate paid by Canadian corporations. Finally, the Liberal Party is now ahead in the polls, with an election set for 2009 at the latest, and their position is still to cut the trust tax rate to 10 percent.
As I’ve written since the Halloween 2006 taxation announcement, no investor should count on anything when it comes to politicians. The good news is full 2011 taxation is still more than priced in for trusts. Any change would create a windfall for investors, and we don’t need one to make money in good trusts.
Further, it’s now crystal clear that there will be no doomsday for good trusts in 2011. That’s the upshot from the generally favorable market reaction to Trinidad Energy Services Income Trust’s (TSX: TDG-U, OTC: TDGNF) announcement this month that it will convert to a corporation this year. The trust still pays the second-highest distribution in its industry and now has the cash flow to grow rapidly.
The fifth major positive this year for trusts is the most speculative but ultimately should have the greatest impact: a long-overdue recovery in natural gas prices. Almost the entire Aggressive Portfolio stands to benefit, though long-suffering Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U) and Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) have the most to gain.
Of course, even the best-run Canadian trusts stand to have plenty of ups and downs this year, particularly in the first half when the US economy will be at its weakest. But by sticking with trusts backed by strong businesses—and adding selectively when the time is ripe—we’ll ride out the bumps. More important, we’ll be in prime position to multiply last year’s 11.4 percent average return for CE picks, as the positives kick in, in earnest.
Portfolio Action
After a generally solid 2007, it’s been a mixed bag for Canadian Edge Portfolio trusts thus far in 2008. Ironically, many of last year’s strongest performers have given ground, while several of those on the weak side last year have gained.
For investors, the key is still buying and holding trusts backed by good businesses. During the next several weeks, the Canadian trust universe will report fourth quarter 2007 results. At this point, each of my Portfolio picks appears headed for a solid showing, which will provide further proof they’ve survived the stress tests of last year and are more than ready for whatever lies ahead.
This month, I’m adding one trust to the Canadian Edge Aggressive Portfolio: High Yield of the Month Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF). The rest of my holdings are all in a buying range for those who don’t already own them or for those making incremental investments.
Again, I don’t recommend “doubling down” or overloading on any position, no matter how cheap it looks. There are just too many unknowns, and bringing down your cost basis only robs you of future tax benefits.
Rather, strive for balance among the portfolio positions. The most risk averse should focus on the Conservative Portfolio, which features trusts backed by good businesses that are a lock to continue paying big distributions well beyond the prospective tax change in 2011. Focused on energy, the Aggressive Portfolio offers the biggest potential returns.
For new readers just getting started investing in trusts, the best starting point is to buy the High Yields of the Month.
High Yields of the Month
This month, both High Yield picks hail from the Aggressive Portfolio. Trinidad Energy Services Income Trust is the first solid trust to announce it will convert to a high dividend-paying corporation and a low-risk but leveraged way to bet on a comeback in natural gas prices. Ag Growth Income Fund is a leading manufacturer of niche products serving the booming North American agriculture industry, whose sales, margins and cash flows have nearly doubled over the past year. For a safe yield of more than10 percent, check out Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), which is reviewed in the Portfolio section.
How They Rate
This issue’s table includes updated safety ratings initiated in the December 2007 issue. The only deletion this month is Fairborne Energy (OTC: FAIRF), which has now converted to a nondividend-paying corporation. My sell recommendation for Fairborne Energy still holds for those who still own it.
I’m replacing it with Bay Street favorite North West Company Fund (TSX: NWF-U). Note next issue, three oil and gas trusts will drop off the list because of the recent completion of mergers. Canetic Energy and Vault Energy Trust are now part of Penn West Energy Trust (NYSE: PWE, TSX: PWT-U). PrimeWest Energy Trust has been acquired by TAQA for CAD26.75 per share in cash.
Here are this month’s advice changes. For changes in buy targets, see the How They Rate Table.
Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF)—From hold to buy @28. This trust continues to make good acquisitions and has now bulked up to a fair-sized entity. Fourth quarter 2007 and full-year 2008 earnings should benefit from strengthening gas prices and oil prices that are still well above last year’s levels.
Daylight Resources (TSX: DAY-U, OTC: DAYYF)—From hold to buy @9. The trust’s dependence on natural gas production means business is volatile. But gas prices appear to be recovering, and the trust expects to cover all capital costs and distributions with cash flow in 2008.
Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF)—From sell to hold. Its industry is still very weak, but the trust’s recently reduced distribution looks stronger after the acquisition of a smaller energy services trust last month. And the share price is extremely depressed as well. It’s for speculators only, though.
Eveready Income Fund (TSX: EIS-U, OTC: EISFF)—From hold to buy @4. Investors treated this trust’s switch to a stock dividend as though it were eliminating its payout entirely. Rather, it’s just conserving cash to make more acquisitions and grow its business in a very weak business environment. That should pay off richly later for aggressive investors who buy in now.
Huntingdon REIT (TSX: HNT-U, OTC: HURSF)—From hold to buy @2. Insurgent investors have captured three board seats in a proxy fight for this longtime underperformer. That augurs good things for this “penny” REIT.
Mullen Group Income Fund (TSX: MTL-U, OTC: MNTZF)—From sell to hold. The transport industry is still on shaky ground, particularly where it involves the still-depressed natural gas patch. But Mullen’s capital spending plans for 2008 are bullish, and management expects the distribution to hold.
Noranda Income Fund (TSX: NIF-U, OTC: NNDIF)—From hold to buy @9. The trust’s shares have been hammered by concerns about the US economy and the impact on profits at the zinc refinery that generates all its royalties. Run by global mining giant Xstrata, however, the refinery remains a very solid operation, and the distribution should hold even if the US economy weakens a bit more.
Feature Article
Canadian trusts took a hit last month from US housing market crisis/credit crunch aftershocks. But the country’s underlying economy and banking system remain strong, providing a powerful underpinning to dividends and therefore ensuring trusts’ ultimate recovery from this—the latest of their stress tests. The Feature Article looks at three challenges facing Canada in 2008 from US troubles: a still-hefty dependence on US markets for exports, the continued strength of the Canadian dollar versus the US dollar and tighter global credit conditions. I look at who’s likely to be most hurt by them until the US cycles out of its current woes, as well as who’s actually thriving on the stress.
Canadian Currents
Slumping natural gas prices have been a major drag on prices of many trusts since late 2005 and the single biggest contributor to distribution cuts as well. The good news is that market appears to be firming. We look at the gas market in Canada and its prognosis over the next 12 to 18 months, which happily appears to be improving.
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—The weak continue to get weaker in the Canadian trust universe. Last month, Clearwater Seafoods Income Fund (TSX: CLR-U, OTC: CWFOF) completely eliminated its payout because of US dollar weakness. Rival Connors Brothers Income Fund (TSX: CBF-U, OTC: CBICF) paid a special distribution to square accounts but didn’t restore a regular payment. CI Financial Income Fund (TSX: CIX-U, OTC: CIXUF) trimmed its payout by 15.8 percent as turbulence in the Canadian financial markets cut into its asset base and management fees. Finally, Eveready Income Fund (TSX: EIS-U, OTC: EISFF) switched to a stock dividend, while Trinidad Energy Services cut its distribution as part of its plan to convert into a high payout corporation. (See High Yield of the Month.)
Tax Matters—It’s almost that time of year again, and Canadian trusts will soon send out distribution information for US shareholders.
Bay Street Beat—The latest on how Canada’s version of Wall Street views income trusts, including several of our favorites.
By the Numbers—Check out our list of conference call dates for any that may pique your interest.
Non-Trust Update—Bank of Nova Scotia is on an international acquistion roll.
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 http://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 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