Our picks have hung in there during an exceptionally difficult environment for one reason: Their underlying businesses have stayed strong, despite the ongoing stress tests of rising raw materials costs, tight credit markets and the weak US economy.

That was the clear message from robust second quarter earnings reports. And they follow solid results from the first quarter as well as the third and fourth quarters of 2007.

As long as this now 14-month-old, North American bear market lasts, we’ll keep our picks under the microscope. The next real opportunity for scrutiny will be third quarter earnings, scheduled for release in late October and early November.

Happily, our favorites have four quarters of strong and stress-tested earnings under their belts. And the longer they stand up to the pressures, the less likely they’ll falter, the safer their dividends are and the sooner buyers will return and push their share prices sharply higher.

Last month, two savvy groups did step up their buying: private capital and company “insiders.” In fact, executives increased purchases this summer at some three quarters of Canadian trusts and corporations tracked in How They Rate.

Meanwhile, private capital firms bought Clearwater Seafoods Income Fund (TSX: CLR-U, OTC: CWFOF) and Sleep Country Canada Income Fund (TSX: Z-U, OTC: SLPCF) well above recent market prices. And rumors have begun to swirl about a lucrative takeover offer for CI Financial Income Fund (TSX: CIX-U, OTC: CIXUF).

Of course, well-run trusts have been cheap for some time. What’s changing is the environment for financing takeovers, which ground to a halt in the second half of 2007 when credit markets tightened.

In contrast to their US counterparts, Canadian banks appear to be successfully absorbing their losses from the global subprime mortgage crisis, and the bite was tiny: Canadians accounted for just 2.2 percent of global subprime related losses and 1.1 percent of capital raised to offset them.

Canada’s economic growth rate has been hit by the US slump. But employment remains tight, the property market is healthy and the banks are solid and ready to lend. That’s evidenced by the continued asset expansion of strong trusts, including the now inked acquisition of US-based driller Grey Wolf by Precision Drilling (TSX: PD-U, NYSE: PDS).

Loosening credit conditions are another good reason to expect strong earnings from our favorite Canadian trusts and corporations for the rest of the year. That plus rising takeover activity augurs for solid total returns in coming months.

Trusts may even be about to catch a break on the 2011 taxation front. Last month, Bonterra Energy Income Trust (TSX: BNE-U, OTC: BNEUF) became the first trust to announce its conversion to a corporation without changing its dividend. And given the market’s favorable reception to its action—and generally hostile initial reaction to converting trusts that have cut—it’s likely to set a trend.

My position remains that the worst case of full taxation has been priced in for trusts since November 2006. What’s not reflected are the unique solutions trusts such as Bonterra will pursue to remain big dividend payers.

With an election likely this autumn for Canada, the possibility of overturning or severely altering the “Tax Fairness Act” is again on the table, as I discuss in the Feature Article. My strategy, however, is still to act as though 2011 taxation is set in stone. And that means focusing on trusts that will do well no matter how they’re taxed—backed by solid and growing businesses, preferably with management that’s committed to paying big dividends to perpetuity.

If the law changes, we’ll get a windfall. If it doesn’t, we’ll still do well as our favorites prove themselves up to the challenge.

These are also the kind of trusts that have weathered the stress tests that began in mid-2006 with the protracted post-Hurricane Katrina decline in natural gas prices. Not only have they held their distributions steady, but many have increased them, some dramatically.

As long as that’s the case, our returns won’t depend on the Canadian government finally seeing reason. All we have to do is keep our eye on earnings and stick with the best. The rest will take care of itself.

Second quarter earnings are all in for CE recommendations. And as last month’s trio of results-related Flash Alerts made clear, the news was universally good, with the exception of two trusts. Both came in worse than we expected and were forced to cut dividends.

One we kept: GMP Capital Trust (TSX: GMP-U, OTC: GMCPF). The “Goldman Sachs” of Canada remains tops in its field, and its woes were entirely related to an almost certainly temporary drop in stock market activity. Note that GMP has moved to the Aggressive Portfolio, where it’s now a buy up to USD14.

The other we sold: Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF). The US Dept of Justice investigation of the ice industry appears to be taking more of a toll than I expected. At the same time, the trust is suffering from soaring transportation costs and customer conservation. We still think Arctic will make it, and its US operations are exempt from the trust tax. But we’re standing aside for now. Note it’s now a buying opportunity for our oil and gas producer trusts.

The September High Yield of the Month from the Aggressive Portfolio is AG Growth (TSX: AFN-U, OTC: AGGRF). The trust overcame supply problems earlier in the year to post robust second quarter earnings and is in the sweet spot of strong global demand for North America’s agricultural output. The Conservative Portfolio play is Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF), a target of strong insider buying over the past two months.

Note that How They Rate now features the following trust groups:

Here are advice changes. See the How They Rate table for updated second quarter payout ratios, as well as for changes in buy targets. Price and yield information is updated every 15 minutes in both tables. Use this service as a reality check when errors occur with US quotes-based services.

Note column four of the table shows dividend frequency and the most likely way each trust will minimize 2011 taxation. “Foreign” indicates non-Canadian income, which is not taxed. “Pools” indicate tax pools used primarily by energy producers, which shield income dollar for dollar. “Depreciation” indicates businesses with large non-cash expenses that can be used to shelter cash flow. “None” indicates no visible method of avoiding 2011 taxes, though some trusts have stated their intention to simply outgrow their future liability and maintain distributions.

• Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF)—Hold to Sell. Per last month’s Flash Alert, I still like this trust, but things could get worse in the near term from the combination of rising transportation costs, customer conservation and the continuing US Dept of Justice investigation into the packaged ice industry. Management bills the dividend cut temporary, but I want to stand aside until the dust clears.
• Bonterra Energy Income Trust (TSX: BNE-U, OTC: BNEUF)—Hold to Buy @ 35. This oil producing trust has found a way to convert to a corporation without cutting its distribution. It’s also focused on sustainability and operates in a great business.
• Crescent Point Energy Trust (TSX: CPG-U, OTC: CPGCF)—Hold to Buy @ 38. This oil producing trust with rapidly expanding output is now back to a good buying price.
• GMP Capital Trust (TSX: GMP-U, OTC: GMCPF)—Hold to Buy @ 14. Second quarter earnings were disappointing and reflect hard market conditions, but the trust is still at the top of its industry.
• Jazz Airline Income Fund (TSX: JAZ-U, OTC: JAARF)—Hold to Sell. Jazz is cutting back on life preservers to save on jet fuel costs. That can’t be a good sign.
• Sleep Country Canada Fund (TSX: Z-U, OTC: SLPCF)—Hold to Sell. Sleep Country has attracted a CAD22 per share all-cash takeover offer from a private capital firm. With the USD price pretty much reflecting the buy price, there’s little to gain from hanging in, and you’ll avoid potential problems getting the cash disbursement.
• Toronto-Dominion Bank (TSX: TD, NYSE: TD)–Hold to Buy @ 62. Toronto-Dominion reported strong volume growth in deposits, real estate secured lending and credit cards.
• Wajax Income Fund (TSX: WJX-U, OTC: WJXFF)—Hold to Buy @ 33. The trust’s CAD25.4 million acquisition of a complimentary business coupled with strong second quarter results paint a good picture.

With Canada likely gearing up for an early election, the trust taxation issue is coming to the fore again. Our take is any change would be positive and likely trigger a windfall gain for trusts across the board but that investors shouldn’t count on one. Meanwhile, what’s far more important for investors are the actions of the trusts themselves. I look at the prospects for a change in the “Tax Fairness Act” and how our favorite trusts are preparing for 2011 in case there’s not one. I also look at the record for early converters from trusts to corporations and how to play them.

Canada’s banking system is the beating heart of its economy. Fortunately, it’s on much steadier ground than the US financial system, as CE Associate Editor David Dittman reveals. Note Canadian financials are highlighted in their own section in the How They Rate table.

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—Three trusts cut distributions last month versus 12 that increased them. The cutters were: Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF), BFI Canada Income Fund (TSX: BFC-U, OTC: BFICF) and GMP Capital Trust (TSX: GMP-U, OTC: GMCPF). Trusts discussed with at risk distributions include: Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF), Extendicare Trust (TSX: EXE-U, OTC: EXMUF), Jazz Airline Income Fund (TSX: JAZ-U, OTC: JAARF) and TimberWest Forest Corp (TSX: TWF-U, OTC: TWTUF). Off the list this month is Noranda Income Fund (TSX: NIF-U, OTC: NNDIF).

Bay Street Beat—How the Canadian analyst community views trusts, including our favorite trusts.

Fixed?—What kind of power does Prime Minister Stephen Harper wield over dissolving Parliament? Not much, except making the request to do so as a matter of Canadian custom.

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.

Note the NAFTA challenge to the Government of Canada’s “Tax Fairness Plan” is heating up. Interested investors should contact: http://www.naftatrustclaims.com/. Also, for late filers, the Income Trust Tax Guide has all the backup you need to file distributions as “qualified dividends.”

Roger Conrad
Editor, Canadian Edge