Private capital is turning to trusts for much the same reason individuals have for several years: big, growing cash flows from steady businesses. As individuals, we’ve reaped the benefits from generous distributions. Private capital will enjoy the same by utilizing a variety of means to escape taxation, in both the US and Canada.

With some $2 trillion of private capital still floating around and trusts trading at huge book-value discounts to their corporate peers, it’s a safe bet we’ll see many more lucrative offers for well-run outfits. Ironically, the new deals may also spur a moderation in the Canadian government’s plan to tax trusts as corporations beginning in 2011.

Fears that foreigners may soon wholly own Canada have been stoked by a Kohlberg Kravis Roberts-led consortium’s pending offer for telecom giant BCE, which was prevented from going trust by the government’s tax moves. The opposition Liberal Party is finding traction with charges that misguided government policies have inadvertently triggered a firesale for Canadian assets. And rumors of a compromise—possibly a reduction in the trust tax rate to 10 percent—are rife.

As far as I’m concerned, we shouldn’t count on buyouts or for Ottawa to change its mind. Both are impossible to forecast with accuracy and, in any case, are well out of our control. Rather, our goal is to continue buying and holding trusts backed by well-run, growing businesses, particularly those with a “Plan B” to keep paying us big dividends well after 2011.

Happily, that’s all we have to do to cash in on the emerging triple play in the trust sector. First, if a good trust is bought out, the price will almost surely be at a steep premium to current levels. Second, if foreign takeovers do spur a change in government policy, almost everything in the How They Rate Table will head a lot higher in a big hurry. And finally, if neither of these things happens, we’ve still got a growing investment paying high income, very likely past 2011.

Doom and gloom always runs rampant in battered markets, often long after they’ve bottomed. That’s certainly the case with trusts now: All but a handful of them touched their lows several months ago and have never looked back.

No one can tell you what some politician will do, on either side of the border. But we do know the worst news on trust taxation has been priced in for some time. Any change from here on in will be positive. On top of that, there’s growing takeover interest and good businesses are still producing strong cash flows.

In short, the investment case is stronger than ever for well-run trusts. Not all will make it. But perhaps more than ever, the best deserve a place in your portfolio, particularly at a time when little else in the income investment arena is in a bargain range.

Portfolio Action

We continue to see gains in the vast majority of Conservative Portfolio and Aggressive Portfolio holdings. The notable exception is Primary Energy Recycling (PRI.UN, PYGYF), which is increasingly encountering problems with operations. The shares are cheap, the assets are still high quality, and the distribution is exempt from Canada’s trust tax law. But in view of the disappointing first quarter results, the distribution must be considered at some risk, so it’s no longer suitable for the goals of the Conservative Portfolio.

I’m swapping it for Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF), which has come down off its highs as it buys Clean Power Income Fund (CLE.UN, CEANF). All other Portfolio holdings remain the same, though I have raised some buy targets slightly.

High Yields Of The Month

The May Conservative High Yield Of The Month is new Portfolio addition Macquarie Power & Infrastructure Income Fund, yielding nearly 10 percent and with a solid track record for growth. The Aggressive Portfolio High Yield Of The Month is Precision Drilling (PD.UN, NYSE: PDS), which is cheap and has put the worst of this energy price slump behind it. It’s also an increasingly likely takeover target.

How They Rate

I’m adding Macquarie Power & Infrastructure Income Fund and Newport Partners Income Fund (NPF.UN, NWPIF) to How They Rate coverage this month. Here are advice changes. For buy targets, see How They Rate or the Portfolio tables. Note prices and yield information is updated every 15 minutes on both tables.

• Chartwell Seniors Housing (CSH.UN, CWSRF) from a hold to buy at USD14. Chartwell won’t qualify as a real estate investment trust (REIT) in 2011 under Finance Minister Flaherty’s definition. But it’s cheap, growing and increasingly operating outside of Canada.
• Clean Power Income Fund (CLE.UN, CEANF) is a tender. Algonquin Power Income Fund (APF.UN, AGQNF) has walked away from its planned buyout of Clean. That means all those who tendered shares can now re-tender to new acquirer Macquarie Power for the latter’s higher bid of 0.5581 of its own shares, plus up to 19 cents Canadian in cash.
• Custom Direct Income Fund (CDI.UN, CUDFF) is a tender. The Edgestone Capital unit of GMP Capital Income (GMP.UN, GMCPF) is offering CD10.20 per share in cash for the trust, a super price for a weak trust. Alternatively, investors can sell now as the shares are fully valued to the deal.
• FutureMed Healthcare Income (FMD.UN, FMDHF) moves from a hold to a buy at USD12. Business is good, and the trust is very well managed, trading at just 1.31 times book value.
• GMP Capital Income (GMP.UN, GMCPF) moves from a hold to a buy at USD22. The investment house trust is building its own private capital fund with which to buy trusts and has made its first purchase.
• Legacy Hotels REIT (LGY.UN, LEGYF) moves from a hold to a buy at USD13. The owner and operator of hotels fails to meet the Flaherty REIT test. But it’s also growing and is heavily owned by insiders.
• Primary Energy Recycling (PRI.UN, PYGYF) is down from a hold to a sell. When a trust’s actual operations continue to disappoint, my discipline is to walk away and take the loss. For more details, see the Portfolio section. 
• TransForce Income Fund (TIF.UN, TIFUF) moves from a hold to a buy at USD13. The trust’s solid franchise and niche markets are protecting it from any slowdown as it accumulates assets.
• UE Waterheater Income (UWH.UN) is a tender. The offer by Alinta Capital of CD23 per share is fair. Alternatively, investors can simply sell, as a competing bid is unlikely.
• Wellco Energy Services Trust (WLL.UN, WLLUF) moves from a hold to a buy at USD6. The trust’s lower distribution rate should hold, and its business is primed to rebound.

Feature Article

I focus on the emerging takeover spree in the Canadian trust industry. I look at the ongoing deals and three types of prospective targets: trusts undergoing strategic reviews, trusts in which insiders and/or private capital firms have acquired large positions—possibly as a prelude to making a full offer—and trusts likely to command the highest premiums in any prospective takeover. Note all Portfolio trusts should be considered potential targets.

Canadian Currents

My strategy is to invest as though corporate taxation of trusts is set in stone for 2011. In reality, however, that’s far from certain. In fact, real positive changes to the Flaherty/Harper plan are still a very strong possibility. Here Canadian Edge Associate Editor David Dittman takes a look at where the trust taxation stands now, amid the swirl of intrigue that is Canadian politics in mid-2007, including the evolving positions and prospects of the major parties. Note the complimentary Maple Leaf Memo (http://www.mapleleafmemo.com/) covers major developments on a weekly basis.

Tips On Trusts

This section is 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—There were no distribution cuts in the oil and gas production sector last month and only one in the energy service sector, Wellco Energy Services Trust. That’s a good sign that these energy price-sensitive sectors have finally hit bottom. Superior Plus Income Fund (SPF.UN, SPIJF) comes off the list this month.

Muddled In Massachusetts—The introduction of a bill by Massachusetts Rep. Neal (D-Mass.) to codify trust distributions as ordinary income in the US set off a one-day panic among some weaker hands. Reality soon sank in that the bill meant little in either the short or long term, and most trusts’ prices have since moved onto much-higher levels. But the incident again underscores US investor pessimism that’s increasingly out of step with trusts’ recovery.

Non-Trust Tips—Last issue, I introduced a basket of dividend-paying Canadian corporations to Canadian Edge coverage. Here, I recap the important developments from their first month on our radar screen. Note that, like trusts, these stocks are cheap and emerging as takeover targets.

Bay Street Beat—I take a look at a recent Bloomberg poll and its ratings of CE 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 intra-day. Clicking on a trust’s name in the table will take you directly to their web sites. 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 a range of other information including 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