When fear rules the market, it really doesn’t matter what you own. Neither high yields nor strong underlying businesses will stem the tide of investor selling.

That’s certainly the lesson from the latter half of 2008. Caught up in the global meltdown, the S&P/Toronto Stock Exchange Income Trust Index lost nearly half its value from the late August peak to its early December bottom. US investors were hit with an additional 24 percent haircut, as the Canadian dollar exchange rate tracked oil prices lower.

Happily, as the Portfolio section shows, our picks didn’t lose nearly that much. But the really good news is we’ve now seen a considerable rally off those lows. The S&P/TSX trust index is up more than 20 percent, while the loonie had rebounded by nearly 10 percent. And the buying has accelerated since the week of Christmas, when Canadian tax selling season finally ended.

Eight more energy producing trusts trimmed distributions last month in response to the cataclysmic drop in oil and gas prices. But even their shares have steadied.

As I’ve written the past couple months, strong businesses paying high yields are obvious targets for investors re-entering the market. My strategy has been to stick the highest-quality Canadian trusts and dividend-paying corporations, as long as their underlying businesses remain healthy. And that’s paid off the past few weeks.

What’s not yet known is whether this is the start of a recovery, or simply a head fake before a dive to new lows. For my money, we should all pay attention to the outlook of my friend George Kleinman, who writes his Futures Market Forecaster from the vantage point of 30 years-plus of successful commodities trading: “Have no stubborn opinions, because it could ultimately be deflation or inflation…(and) certain commodities (food, gold) could possibly surge in deflation or inflation, while others could fall in either scenario.”

That advice is definitely applicable to individual stocks and trusts. Simply, some will do well under either weak growth/deflation or strong growth/inflation, and some will do poorly under either outcome.

The weak US economy is hitting the underlying businesses of many trusts and high dividend paying corporations in Canada. Producers of raw materials including energy have been particularly hard hit by the drop in commodity prices in recent months. But other businesses have also taken knocks, from real estate to health care.

Governments worldwide, including Canada, are pumping out unprecedented fiscal and monetary stimulus. In the US, the federal funds rate is nearly zero, while the incoming Obama administration plans nearly USD1 trillion in new spending and tax cuts. Canada also plans massive new expenditures, including on infrastructure.

Market history shows that spending of this magnitude eventually revives global growth. And once it does this time, demand for commodities will rebound, and so will prices.

With its bounty of natural resources to export, Canada will be a prime beneficiary, just as it was up until September 2008. That in turn will spur a strong recovery in trusts and high yielding corporations, with US investors’ gains compounded by a corresponding surge in the loonie.

It’s clear now that global governments won’t shirk from their commitment to head off worldwide deflation until the job is done. What’s not known is how much more will have to be done and how long it will take to have an impact.

Canadian trusts and other equities have bounced back in part because expectations for growth have improved and oil prices have come well off their lows. As I point out in the Feature Article, we’re virtually guaranteed another upward spike for energy when global demand revives, mainly because so many plans for future production have been postponed or cancelled. And demand could revive a lot sooner than expected if my colleague Yiannis Mostrous is correct in his analysis that China will keep growing in 2009.

Oil prices, however, could easily turn around and head south should the mood on the global economy darken in the near term. And that could certainly unwind the recent gains we’ve seen for Canadian trusts, including those that don’t produce energy.

In short, this isn’t yet a rising tide to raise all boats. Rather, we’ve still got to painstakingly separate the trusts and dividend-paying corporations with strong underlying businesses from the pack. And any picks that falter along the way need to be unloaded, regardless of how their shares have performed.

The next set of hard numbers we’ll see will be fourth quarter earnings. Unfortunately, waiting on them will take patience, as trusts must collect and process a huge volume of data. In fact, if history is any guide, we won’t see all of the results until the first quarter is nearly over.

For some investors, that delay might be too heavy a cross to bear with the Wall Street consensus so overwhelmingly negative. My only admonition is to remember three things.

First, Canadian Edge recommendations have already come through two and a half years of stress tests, and those still standing are a hearty breed indeed.

Second, value does ultimately command a fair price in the marketplace. The late December/early January action may or may not be the beginning of a more explosive run. But we will eventually see one, and it will propel trusts that hold it together as businesses much higher.

And third, we’re still getting some of the juiciest dividends on the planet, many of which are likely to be increased in 2009.

Expect some jolts ahead. But ultimately, if we’re patient and watchful this combination is going to pay off richly. And odds are it will happen when we least expect it.

Portfolio Action

I’m not making any changes to the Canadian Edge Portfolio this month. All holdings are now buy-rated, including Provident Energy Trust (TSX: PVE-U, NYSE: PVX), which I’ve upgraded due to its very low valuation of just 90 percent of book value.

The current lineup represents the strongest Canadian trusts and corporations from a wide range of sectors. My best advice for all readers is to try to build a roughly equally weighted mix of at least eight to 10 of them. Income seekers should lean more heavily on the Conservative holdings, whose distributions are not directly tied to energy prices. Those interested in a high distribution bet on energy will want to focus more strongly on the Aggressive holdings.

All of our holdings have rallied over the past month, some quite strongly. For example, last month’s Conservative addition Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) is up more than 70 percent since. We’re still a long way from making back 2008 losses. But more important, every holding is still trading below its buy target, which is based on my valuation of its underlying business and long-run dividend-generating power.

High Yields of the Month

I’ve drawn both January 2009 High Yield of the Month entries from the Conservative Portfolio. Both are long-time holdings that present huge value and dividend-paying potential well past 2011 taxation.

AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) trades for little more than what it did when I first picked it up in February 2005, despite major additions to its portfolio of solid, cash-generating energy infrastructure. It also yields well over 12 percent, despite a long-term record of steady, robust dividend increases.

Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) yields over 11 percent and trades for just 74 percent of book value, despite continuing to generate steady, recession-resistant cash flow. The trust has also caught a break from the collapse of the leveraged buyout of parent BCE (TSX: BCE, NYSE: BCE), which removed significant event risk.

How They Rate

How They Rate features the following trust groups:

• Oil and Gas–All producer trusts are included here.
• Electric Power–Power generators.
• Gas/Propane–A mixture of distributors, from propane to packaged ice.
• Business Trusts–A range of businesses involved principally with consumers.
• Real Estate Trusts–All qualified real estate investment trusts.
• Trust Mutual Funds–Closed-end funds holding portfolios of individual trusts.
• Natural Resources–Trusts and corporations that produce resources and raw materials other than oil and gas.
• Energy Services–Trusts and corporations whose main business is providing drilling, environmental or other services to energy producers.
• Energy Infrastructure–Trusts and corporations that own primarily pipelines, processing facilities and other fee-generating assets.
• Information Technology–Trusts and corporations that provide communications, newspaper, directory and other information services.
• Financial Services–Canada’s banks, investment houses and other trusts and corporations feeding that business.
• Food and Hospitality–Trusts and corporations that franchise restaurants, own and operate hotels and manufacture and distribute food and beverages.
• Health Care–Trusts and corporations involved in the medical care and/or supply business.
• Transports–Trusts and corporations that ship freight and move passengers by bus, truck, rail or air.

Here are advice changes. Note I’ve changed buy prices on a number of trusts this month to reflect the disaster hitting the credit markets and the likelihood of slower economic growth in North America.

See the How They Rate Table as well 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.

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.

BCE (TSX: BCE, NYSE: BCE)–New addition: Buy @ 22. The takeover deal for the company failed. But selling for six times earnings, 1.3 times book value and a yield of nearly 6 percent, the stock’s again cheap and the business itself is still reasonably recession resistant.

Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF)–Sell to Hold. I sold this one from the CE Portfolio last month to take the tax loss. I like other power trusts better, but if the distribution holds this one will recover a good chunk of lost ground this year.

Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF)–Hold to Buy @ 22. Investor pessimism on oil patch prospects runs deep and last year’s steep drop in oil prices hurt cash flows. But the Syncrude partnership this trust represents is extremely solid, and these shares are at their lowest levels since early decade, when output was much lower.

EnerVest Diversified Income Trust (TSX: EIT-U, OTC: EVDVF)–Sell to Hold. There are better funds, but this one isn’t going to disappear. And a rising tide in the trust market will raise all boats, eventually at least.

GMP Capital Trust (TSX: GMP-U, OTC: GMPCF)–Sell to Hold. I sold this one in December to take a tax loss. It won’t recover until the Toronto market makes a serious comeback, but this is still a solid franchise for the very patient.

H&R REIT (TSX: HR-U, OTC: HRREF)–Hold to Buy @ 7. The REIT now has financing for the massive office building it’s constructing for EnCana (TSX: ECA, NYSE: ECA) and the 50 percent distribution cut is on the books and in the share price.

InStorage REIT (TSX: IS-U, OTC: INREF)–Buy @ 3.25 to Sell. The takeover by a larger entity at CAD4 per share looks like the best shareholders will get. US investors should avoid the potential tax hassles by selling before consummation.

Newport Partners Income Fund (TSX: NPF-U, OTC: NWPIF)–Hold to Buy @ 0.50. This trust’s problem has never been about the quality of the individual holdings in its diverse investment portfolio. Rather, it’s been about its competence managing them for overall profits. New leadership makes a turnaround a worthy speculation. Note there’s no distribution, so this one is only for very patient speculators.

Provident Energy Trust (TSX: PVE-U, NYSE: PVX)–Hold to Buy @ 6. Provident’s cash flow has fallen with lower prices for oil, natural gas and gas liquids. But selling for just 90 percent of book value, its price reflects a whole lot of future bad news that isn’t likely to happen.

The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Hold to Buy @ 6. Will people eat out less in a recession? That doesn’t seem to matter if your restaurants are popular and well-located and management continues to boost the royalty pool, and future distributions.

TransAlta Corp (TSX: TA, NYSE: TAC)–Hold to Buy @ 22. The collapse of a hostile takeover bid has hit the stock far out of proportion to the risks and it’s cheap again.

TimberWest Forest Corp (TSX: TWF-U, OTC: TWTUF)–Hold to Sell. The company is not only having problems selling its timber products into a weak home building market, but it’s also facing opposition developing its lands on Vancouver Island as real estate.

Feature Article

Falling oil and natural gas prices turned the latter half of 2008 into a bloodbath for energy producer trusts, marked by cascading share prices and distribution cuts. Losses for US investors were compounded by the precipitous drop in the Canadian dollar, which basically tracked oil’s tumble.

The good news: What goes down that dramatically almost always comes back up with a vengeance, providing the underlying businesses are still solid. Stress tested since mid-2006, unburdened by heavy debt and armed with ultra-reliable, long-life reserves, the best energy trusts are weathering the storm, and are seeing new life in early 2009. Here’s what to expect for energy producing trusts for the rest of the year, and where the best bets are.

Canadian Currents

In normal times, a ruling party’s budget is fiat after it’s released. That was certainly the case on Halloween 2006, when the Conservative Party announced dramatic future changes to the taxation of income trusts.

But despite picking up seats in last year’s election, this year’s budget carries particular importance for the ruling party, as it faces a potential revolt by the all three major opposition parties.

Rumor has it that this year’s edition will contain a great many goodies, including some with great potential for income trust investors. David Dittman has the details. 

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–As the Feature Article notes, trusts’ December distribution cuts were heaviest in the energy patch, where eight more made cuts. That’s to be expected when oil prices fall by more than USD100 a barrel and gas prices drop in half over just a few months. And history shows such reductions can and will reverse quickly when energy prices return to the upside.

That also goes for Precision Drilling Trust’s (TSX: PD-U, NYSE: PDS) planned reduction, made in conjunction with the completion of its merger with Grey Wolf.

The other cuts in the trust universe, unfortunately, may be more difficult to reverse, as they’re related to credit and economic woes: Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF), Extendicare REIT (TSX: EXE-U, OTC: EXMUF), FutureMed Healthcare Income Fund (TSX: FMD-U, OTC: FMDHF), H&R REIT, Interrent REIT (TSX: IIP-U, OTC: INREF), InStorage REIT, Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF), PRT Forest Regeneration Income Fund (TSX: PRT-U, OTC: PFSRF), Sentry Select Dividend Income Trust (TSX: SDT-U, OTC: SSDUF) and TimberWest Forest Corp.

I discuss all of them in depth.

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

Canada’s Tax-Free Savings Account–It’s not open to US-based investors, but a new savings vehicle could have positive implications for all trust investors.

Tax Prep–As is our practice this time of year, we’ll soon be compiling links to trusts’ statements on the US treatment of their respective distributions.

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 preeminent 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 go to 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