“Undue expansion.” That was the ruling from Canada’s Dept of Finance on Colabor Income Fund’s (TSX: CLB-U, OTC: COLAF) takeover of rival food services firm Summit Food Service Distributors. As a result, Colabor became the first trust subjected to the tax on specified investment flow-through entities (SIFT).

The SIFT tax will be applied to all income trusts beginning Jan. 1, 2011,  provided they don’t first convert to corporations. For Colabor unitholders, however, paying taxes was basically a nonevent. The trust still comfortably covered its distribution and stayed on course for robust long-term growth, and its share price remained steady.

Not every trust will prove as immune to SIFT taxation as Colabor. But with Trinidad Energy Services (TSX: TDG-U, OTC: TDGNF) rallying strongly after announcing its conversion to a corporation, it’s increasingly obvious the market’s fears of a 2011 doomsday for trusts are pure fantasy. In fact, the closer we get to 2011, psychology will improve and trusts backed by good businesses will gain ground, even if the current tax law remains intact.

As the Feature Article points out, the battle to undo Flaherty’s folly is still raging. In fact, this month the Green Party added its voice to the Liberals and Bloc Quebecois in criticizing the Conservative Party government policy to tax income trusts.

I’m hopeful, but we really don’t need action in Ottawa to make money. Trusts across the board are selling at huge discounts to equivalent corporations. So if the law is changed, they’ll stage the mother of all rallies. Meanwhile, if there’s no change, the good ones will continue to prove that they can pay big dividends in a post-2011 world, and prices will move higher on their own.

Although the threat of 2011 taxation may be rapidly turning into a paper tiger, some trusts continue to face a trio of stress tests in early 2008: the threat of a global spillover from the US slowdown, the still very strong Canadian dollar and financial market weakness.

Last month, trust distribution increases far outweighed reductions once again. But the impact of these challenges did show up in the fourth quarter earnings of more than a few individual trusts, including some in the Canadian Edge Portfolio. The potential for a deeper impact is one of my major concerns, at least for the first half of the year. And the perceived risk of one is why several of my favorites have taken on water this year, despite posting strong fourth quarter results and positive outlooks for 2008.

The lighter side is that these trusts are now pricing in a lot worse news than we’ve seen already. If they can hold their numbers, they’re headed for huge gains when the financial markets cycle out of this climate of fear. And barring an absolute disaster, downside risk is strictly limited from here.

Ironically, the bright spot in the trust universe this year was last year’s chief laggard: energy, particularly natural gas. Oil has grabbed the headlines and deservedly so, given its unprecedented surge above the century mark. But natural gas has made the more dramatic move, finally breaking out of a two-year slump to move past $9 per million British thermal units.

Weak gas was a major factor holding back producer trusts’ cash flows and share prices last year. But improvement began in the fourth quarter as firming gas prices helped drive trust earnings higher. Now with near-term gas futures nearly 50 percent above most trusts’ fourth quarter selling prices, the stage is set for a dramatic upturn, particularly when the North American economy starts to recover later this year. That means big gains for favored Aggressive Portfolio energy trusts, even as they continue to pay us the highest dividends in the world.

As the How They Rate Table and Dividend Watch List (see Tips on Trusts) make clear, there remain some very real pockets of risk among Canadian trusts. Some are still in death spirals toward oblivion, while others are perilously close to tipping over. More than a few didn’t comfortably cover distributions in the fourth quarter, putting them at serious risk to cuts and big losses if things don’t break their way in 2008.

The key is to be steady and selective when you buy, and diversified and skeptical about what you own. That doesn’t mean your positions won’t take on water in a bear market like this one. And it doesn’t ensure you won’t have an occasional blowup either, as I’ve suffered with Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF).

This is the best and only way, however, to ensure your portfolio emerges from the current turmoil in sound shape. And that is the key to locking in great results when better days finally return.
 
Portfolio Action

Last month, I made two new additions to the Canadian Edge portfolios. The Mutual Fund Alternatives picked up Series S-1 Income Fund (TSX: SRC-U, OTC: SRIUF), a little-known closed-end fund with a focus on infrastructure trusts. To the Aggressive Holdings, I added AG Growth Fund (TSX: AFN-U, OTC: AGGRF), a fast-growing play on the rapid growth of American agriculture. Both have since scored solid returns, particularly AG Growth. Both remain solid buys for those who didn’t get in.

This month, with most fourth quarter results in, we’ve gotten a fairly decent update as to how our picks have been affected by the economic challenges they face. I put the numbers in context in the Portfolio section. Note there are no changes to holdings this month, though several buy targets have been adjusted.

Also, my two trusts with disappointing fourth quarter results so far—Boralex Power Income Fund and TransForce Income Fund (TSX: TIF-U, OTC: TIFUF) are now holds. I expect an improvement in both trusts’ results by midyear at the latest, while TransForce should get some stability when management makes clear what it means by “strategic initiatives.”

High Yields of the Month

Both of my High Yield of the Month picks hail from the Conservative Portfolio: Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) and Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF). The key attractions they have in common are generous yields, exceptionally strong energy infrastructure businesses, solid balance sheets and robust, reliable dividend growth.

Both are also very cheap relative to equivalent corporations, with Keyera selling for just 82 percent of sales and Macquarie for 1.08 times book value. Both trusts have also announced fourth quarter earnings, with no surprise and no evidence they’re being affected by sluggish US economic growth.

How They Rate

This month, four oil and gas trusts have dropped off How They Rate coverage because of takeovers: Canetic Energy Trust, Focus Energy Trust, PrimeWest Energy Trust and Vault Energy Trust. 2007 tax information for US investors in PrimeWest can be found on its Web site or by contacting Computershare at 800-564-6253. Information for Canetic and Vault can be found on the Web site of their acquirer, Penn West Energy Trust (NYSE: PWE, TSX: PWT-U). For Focus information, visit the Web site of its acquirer Enerplus Resources (ERF.UN, NYSE: ERF).

All other listings remain the same. Note there’s currently one pending takeover deal involving How They Rate trust Spectra Energy Income Fund (TSX: SP-U, OTC: SPFFF).

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

• Baytex Energy Trust (NYSE: BTE, TSX: BTE-U)—Hold to buy @22. Baytex increased its proved reserves 13 percent in 2007 and at the same time held finding, development and acquisition (FDA) costs 38 percent below their three-year average.
• Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF)—Buy @8 to hold. After a 22 percent cut last month, the new distribution level should hold. But until the numbers start to turn up, it’s not worth committing more funds.
• Boston Pizza Royalties (TSX: BPF-U, OTC: BPZZF)—Hold to sell. I don’t like it when a trust’s long-time investor and sponsor can’t seem to wait to sell out, as this one’s parent appears to be doing.
• Canfor Pulp (TSX: CFX-U, OTC: CFPUF)—Buy @13 to hold. This still looks like the survivor of this challenged industry, but disappointing fourth quarter numbers sound a cautionary note at least to mid-2008.
• Colabor Income Fund (TSX: CLB-U, OTC: COLAF)—Hold to buy @12. The trust managed to grow, pay dividends and absorb the SIFT tax in the fourth quarter of 2007. That’s a pretty clear testament that it runs a good business.
• Contrans Income Fund (TSX: CSS-U, OTC: CSUIF)—Hold to buy @9. This transport trust hasn’t expanded as fast as TransForce Income Fund in recent years. But that conservative approach is paying off with a more protected distribution now.
• Freehold Royalty Trust (TSX: FRU-U, OTC: FRHLF)—Sell to hold. The royalty trust doesn’t pay a qualified dividend for US investors. But strong fourth quarter production results from its lands and a still-low realized selling price for the output are signs of a solid business.
• North-West Corp (TSX: NWF-U)—Hold to buy @20. More solid results and expansion for this strong business lie ahead as expansion into Alberta’s remote reaches shows.
• Peak Energy Services Trust (TSX: PES-U, OTC: PKGFF)—Sell to hold. A new credit agreement takes bankruptcy out of the picture. With industry conditions improving and the Wellco Energy Services (TSX: WLL-U, OTC: WLLUF) merger nearing, this is looking more and more like a bottom.
• TransForce Income Fund (TIF.UN, TIFUF)—Buy to hold. The selling is more than done, but the trust’s rapid expansion over the past year has taken its toll: Revenue hasn’t caught up to costs. A dividend cut now looks likely.
• Trilogy Energy (TSX: TET-U, OTC: TETFF)—Sell to hold. The trust seems to have turned the corner after a 64 percent sequential gain in output from the third to fourth quarter 2007.
• Wellco Energy Services (TSX: WLL-U, OTC: WLLUF)—Sell to hold. See Peak above.

Feature Article

The 2011 tax issue has clouded investors’ outlook on Canadian trusts for more than a year and a half. But in contrast to when Finance Minister Flaherty made his Halloween 2006 announcement, we now have at least some clue on how the tax change will and won’t affect individual trusts.

I look at the state of the trust tax today and the continuing prospects for its repeal. I analyze how trusts will be affected and how they’ll bring their ultimate tax bill far below where the consensus has it pegged today. And I run down how the Canadian Edge Portfolio picks stack up.

Canadian Currents

As we’ve been pointing out since this advisory’s inception, Canada’s edge extends to a lot more than just income trusts. Here we look at the country’s top corporations, which we’ll be highlighting in future issues of Canadian Edge.

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—There were only two distribution cuts last month versus seven increases. I review the prospects of the two cutters, Boralex Power Income Fund and PRT Forest Regeneration Fund (TSX: PRT-U, OTC: PFSRF). I also look at other trusts that showed weakness in the fourth quarter that could lead to a future distribution cut. See the table in this section of the comprehensive list of endangered dividends.
The Power to Tax—The Income Trust Tax Guide has links to all of the trusts’ Web sites providing information on how their dividends should be treated for US tax purposes. Note virtually all should be treated as qualified dividends. The information on the trusts’ Web sites is excellent backup for filing them that way, even if your broker is mistakenly listing them as ordinary income.
Bay Street Beat—How the Canadian analyst community views trusts, and how to use that information.
Ottawa Watch—Here’s the latest in the always volatile world of Canadian politics, with a focus on issues dear to income trusts.

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 intraday. For other information, go directly to a trust’s Web site 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