Editor’s Note: What follows is the executive summary of the May 2013 issue of Canadian Edge. Thanks for reading.

Welcome to issue No. 107 of Canadian Edge. This marks the beginning of another new era for a publication that will soon enter its second decade, as I assume the role of Chief Investment Strategist in lieu of my longtime colleague, mentor and friend Roger Conrad.

I’ve been working side by side with Roger on CE since the beginning in August 2004. My first assignment, which reflected Roger’s desire to capitalize on my law degree, was to research and write a piece on tax issues for US investors who owned Canadian income trusts.

Soon I was writing a regular feature in the Tips on Trusts section focused on new income trust conversions and initial public offerings. In September 2006 I created Maple Lead Memo, the weekly companion to the regular monthly issue.

MLM debuted just in time for the event that marked the beginning of the end of what we might call the first era of Canadian Edge. Within weeks of its first issue we were covering the aftermath of the “Halloween Massacre,” Canadian Finance Minister Jim Flaherty’s Oct. 31, 2006, announcement that Canada would begin taxing income trusts as corporations as of Jan. 1, 2011.

Many observers–including people inside our shop–thought Mr. Flaherty’s announcement was a “death knell” for CE.

Roger and I believed otherwise. Even then it was clear that investor hunger for yield–demand, as it were–would drive publicly traded companies to continue efforts to pay market-beating dividends as a way of attracting capital.

We also knew that Canada built into its SIFT legislation a four-year transition period during which companies could not only convert to corporations with very limited tax implications but could also orient their financial and operating policies in ways that supported relatively high dividend rates. Thus supply. And thus the second era of Canadian Edge.

From the very beginning of CE, setting aside issues of favorable entity-level taxation and its implications for yields, the focus has been on high-quality stocks of strong businesses with easily understood cash flows, solid financial management and track records of success within their particular fields of operation.

Underpinning our analysis then and now is the CE Safety Rating System, whereby our research team scores companies in the How They Rate coverage universe on a set of criteria that help us establish the quality of the underlying business.

The payout ratio remains the cornerstone of the System. It’s basically the dividend as a percentage of profits available to pay dividends.

Two of the six points in the Safety Rating System are determined by payout ratio. If a company’s payout ratio comes in below a certain level required for its sector, it gets a point. If it’s superior for its class, and the payout ratio will likely stay in the safe zone for the next 18 to 24 months at least, the company will score two points.

Two more are determined by debt. Companies get a point for having a debt-to-assets ratio below a certain percentage designated for their group. They get another point if total obligations coming due the next two years as a percentage of total market capitalization (outstanding shares times share price) are less than 10 percent. The result is a gauge of refinancing risk for each company reviewed.

Criterion No. 5 is the nature of the business of each company. Basically, some business models are better suited to supporting dividends throughout the business cycle. Others are more susceptible to economic shocks.

Among the most resilient are pipeline, electric power, select infrastructure and various consumer-focused companies whose cash flows have proven to be steady over time.

By contrast, resource-focused names such as oil and gas producers are often subject to wild swings due to ups and downs for commodity prices, which can help or harm cash flows and, thus, dividends.

Companies in economically resistant businesses receive a Safety Rating point on this score, while resource companies do not.

The last criterion under the Safety Rating System is simply whether a company has cut its dividend over the past five years. If it hasn’t it gets a point; if it has reduced its payout it doesn’t get a point. This is a significant factor, as the last half-decade witnessed the worst global economic downturn since the Great Depression.

Companies that endured without reducing their dividends have been tested under the harshest of circumstances.

The Safety Rating System establishes a framework for analysis. We’ll continue to abide by what it tells us about quality.

The CE Portfolios have done a great job building wealth for subscribers over the past nine years. And I take some pride in having identified, researched and recommended several winners, some of which remain in the Portfolio today.

I first wrote up former Portfolio Holding Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) in Tips on Trusts when it converted into Penn West Energy Trust in 2005. I featured current Holdings Cineplex Inc (TSX: CGX, OTC: CPXGF, 107 percent total return), Bird Construction Inc (TSX: BDT, OTC: BIRDF, 382 percent), Ag Growth International Inc (TSX: AFN, OTC: AGGZF, 46 percent) and Shaw Communications Inc (TSX: SJR/B, NYSE: SJR, 28 percent) in the old Tips on Trusts feature on new conversions, in MLM or via Canadian Currents.

I remain confident in the long-term wealth-building potential of Cineplex, Bird, Ag Growth and Shaw.

In addition to making these “finds,” I’ve had the opportunity, in CE’s companion advisory Australian Edge, to which many of you now subscribe, to construct and manage a portfolio along the lines established here.

I’ll note that the 24 Holdings that comprised the AE Portfolio at the end of the publication’s first full year generated an average total return–capital gain or loss plus dividends paid–of 25.5 percent in US dollar terms in 2012. Including two positions that we opened and closed during 2012 the average US dollar total return was a little lower at 20.8 percent.

By comparison, the S&P 500 Index returned 16 percent for US-based investors, including dividends, while the MSCI World Index was up 16.6 percent.

I’ve very much enjoyed identifying and researching stocks for inclusion in both the CE and AE portfolio. The desire to do more research was one of the main reasons I left my career as a broker and turned to financial writing.

Running portfolios boils down to stock selection. But it’s important to understand the big picture as well.

And MLM has been the venue where we’ve most consistently trumpeted the relative strength of the Canadian economy versus its developed-world peers, covering extensively the moves made by fiscal and monetary authorities that ensured the Great White North would survive and emerge from the Great Recession in better shape than most.

I was on the “Canadian miracle” story early, and I knew from the beginning that it wasn’t any supernatural intervention that made it such a compelling narrative. Shrewd, effective governance, including rational regulation of what remains one of the world’s soundest financial systems and responsible management of a still-ample store of natural resources, has been and will be the key to Canada’s long-term viability as a destination for investor capital.

But it all boils down to individual businesses and their ability to generate cash flow to sustain and grow dividends. To this end my approach, as the head of our research team, will be guided by three principles:

• Work the CE Safety Rating System.
• Let winners run.
• Be quick but not hurry to admit mistakes and move on.

Aggressive Holdings Extendicare Inc (TSX: EXE, OTC: EXETF) and Colabor Group Inc (TSX: GCL, OTC: COLFF) present immediate opportunities to test our commitments. The former announced a 42.8 percent dividend cut this week, while the latter posted less-than-stellar numbers for the first quarter of 2013.

We have details on Extendicare in Dividend Watch List, while Colabor’s situation is discussed in Portfolio Update.

The goal for me and my lead analyst Ari Charney, along with the rest of the Investing Daily research team, over the coming months is to continue to provide you the same level of outstanding investment research and advice you’ve come to trust in Canadian Edge.

In the end I expect nothing less than to be held accountable for the decisions we make. The standard is market-beating returns, and I intend to meet it.

I look forward to hearing from you in the “Comments” section at the bottom of article pages at www.CanadianEdge.com.

Welcome to the third era of CE. Thanks for reading.

David Dittman
Chief Investment Strategist, Canadian Edge

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Portfolio Update

 

Seven members of the Canadian Edge Portfolio have reported operating and financial results during the past month.

Conservative Holding Shaw Communications Inc (TSX: SJR/B, NYSE: SJR) posted numbers for its fiscal 2013 second quarter. Fellow Conservative Holdings AltaGas Ltd (TSX: ALA, OTC: ATGFF) and TransForce Inc (TSX: TFI, OTC: TFIFF) reported for the first quarter of calendar 2013.

Aggressive Holdings ARC Resources Ltd (TSX: ARX, OTC: AETUF), Colabor Group Inc (TSX: GCL, OTC: COLFF), PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) and Vermilion Energy Inc (TSX: VET, NYSE: VET) all reported results for the first quarter of calendar 2013.

All but Colabor reported numbers that support dividends and growth over time. Colabor is now a hold.

Note that Extendicare Inc (TSX: EXE, OTC: EXETF), which won’t report results until May 9, cut its dividend by 42.8 percent this week. Extendicare’s situation is addressed in Dividend Watch List. Extendicare is now a hold.

Portfolio Update has a roundup of first-quarter financial and operating results for the first seven Holdings to report this season.

 

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Best Buys

On April 18, 2013, Dundee REIT (TSX: D-UN, OTC: DRETF) confirmed its monthly distribution for May: CAD0.18666 per unit, or CAD2.24 on an annualized basis. That’s up from the CAD0.183, or CAD2.20 on an annualized basis, the REIT paid unitholders in April.

It’s a modest, 1.8 percent boost. But it’s notable because it’s the REIT’s first-ever distribution increase. And it’s enough to earn the REIT, a CE Portfolio Conservative Holding since February 2012, an increase in its buy-under target to USD39.

What makes Dundee REIT one of two Best Buy recommendations for May are its portfolio of high-quality properties that are occupied by high-quality tenants; the fact that it’s maintained a steady distribution for nearly a decade, surviving a serious recession during this span; and that management continues to demonstrate solid judgment, in terms of maintaining conservative financial policies as well as sticking to a disciplined, focused approach to portfolio management.

Dundee REIT, which will report first-quarter results on May 8, is a buy under USD39.

The second of May’s Best Buy recommendations–Aggressive Holding Parkland Fuel Corp (TSX: PKI, OTC: PKIUF)–will also report its results for the first three months of 2013 on May 8.

In mid-April management provided an update on what it calls the “Parkland Penny Plan,” a modestly named initiative that’s beginning to bear significant fruit.

The Parkland Penny Plan is a five-year strategic effort that aims to double 2011 normalized earnings before interest, taxation, depreciation and amortization (EBITDA) of CAD125 million by the end of 2016.

Parkland stock traded at an all-time high above CAD20 on the Toronto Stock Exchange (TSX) as recently as mid-February. But it took a big hit after management reported fourth-quarter and full-year 2012 results on Feb. 26 and has since drifted to a 2013 closing low of CAD15.81 on April 23.

That’s despite the fact that actual numbers were in line with management’s monthly updates leading to the quarterly and annual reports. And that’s despite the fact that management boosted the fuel distributor’s dividend for the first time since it converted from an income trust to a corporation in January 2011.

Like Dundee’s, Parkland’s new monthly dividend rate is only modestly higher, at CAD0.0867 versus CAD0.085. That’s a mere 2 percent, and the annual rate is now CAD1.04 versus CAD1.02. But it reflects management’s confidence in its ability to execute on the Parkland Penny Plan.

Parkland Fuel is a buy under USD18.

Best Buys–which features the top two candidates for purchase in April–is the place to start if you have money to put to work right now.

 

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In Focus

The Canadian dollar has been below parity with the US dollar since February, and the prevailing bet is that it’s headed even lower from here.

But a solid case can be made that the loonie has more room to soar, as central bank purchases of Canadian dollar-denominated assets continue, the International Monetary Fund has granted it new status and underlying long-term fundamentals remain strong.

The loonie has held up over the past couple months as gold and oil have suffered significant downside shocks, suggesting that Canada’s is no longer simply a petrocurrency. Meanwhile, at the same time oil and metals prices are sagging the other 50 percent of Canada’s export base is surging.

If you’re a US-based investor who’s long Canadian equities, you’re also long the Canadian dollar. That means share-price gains and dividends are augmented by the loonie’s appreciation versus the buck. And compelling evidence suggests a loonie below parity represents a strong buying opportunity in a long-term context.

In Focus takes a look at specific ways to put money to work in the Canadian dollar.

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Dividend Watch List

Aggressive Holding Extendicare Inc (TSX: EXE, OTC: EXETF) has succumbed to pressure on US Medicare funding as well as the impact of sluggish economic growth on occupancy at its senior care facilities. Management announced this week a 42.8 percent reduction in the monthly dividend to CAD0.04 from CAD0.07, effective with the June payment.

Extendicare has been on the Dividend Watch List since December 2012 because of its exposure to an increasingly uncertain US health care market, which accounted for more than 60 percent of fourth-quarter 2012 revenue and earnings before interest, taxation, depreciation and amortization (EBITDA).

Management attributed the cut to changes in the US operating environment, including significant cuts in government funding, increases in alternative care and increased regulation.

“The company’s US cash flow will principally be used to enhance operations, provide financial flexibility and become responsive to future changes in funding,” President and CEO Tim Lukenda said in a statement announcing the move.

The new rate will allow Extendicare “to be adaptable to an evolving US health care marketplace” and gives the company “strength and flexibility…to navigate uncertainty in the near term.”

Even more unsettling, if that’s possible, is that management said in the same announcement that it expects to report first-quarter funds from operations of CAD0.17 per share and adjusted funds from operations of CAD0.21 per share when it posts numbers for the first quarter of 2013 on May 9.

By contrast, Extendicare generated adjusted funds from operations–the best measure of the business’ underlying health–of CAD0.312 during the fourth quarter of 2012. That figure covered the old CAD0.07 monthly dividend by a 1.49-to-1 margin, the equivalent of a 67.3 percent payout ratio.

First-quarter guidance is based on “continuing U.S. economic weakness resulting in reductions in both funding and census,” or the number of residents in its senior care centers.

Extendicare–the only member of the How They Rate coverage universe to cut its dividend last month–is now a hold.

Dividend Watch List has more on How They Rate companies whose regular payouts are in jeopardy.

 

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Canadian Currents

Canada’s GDP grew at a higher-than-expected rate for February, and the January figure was revised higher. Still, economists expect the economy to decelerate in 2013, with a moderate rebound thereafter.

Canadian Currents focuses on the latest macro news from the Great White North and provides some details about the man who will replace Mark Carney as Governor of the Bank of Canada.

Bay Street Beat–First-quarter 2013 earnings reporting season is now underway. Here’s how Bay Street feels about the first group CE Portfolio Holdings to post numbers.

Bay Street Beat has the latest on what analysts are thinking about our favorites.

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How They Rate Update

 

Coverage Changes

The merger of AvenEx Energy Corp, Pace Oil & Gas Ltd and Charger Energy Corp to form Spyglass Resources Corp (TSX: SGL, OTC: PACED) is now complete.

Spyglass has replaced AvenEx and Pace in How They rate under Oil & Gas.

Trading in Poseidon Concepts Corp (TSX: PSN, OTC: POOSF) remains halted. There are a number of shareholder suits ongoing against the company. One US law firm participating is Howard G. Smith of Bensalem, Pennsylvania (888-638-4847).

Given how fast this one imploded, no one should get their hopes up for much restitution. But by the same token shareholders have little to lose, either. Sell Poseidon Concepts at the first possible opportunity.

The acquisition of Primaris Retail REIT by H&R REIT (TSX: HR-U, OTC: HRUFF) was completed on April 4. Unitholders should have received by now some combination of 1.166 units of H&R and CAD28 per unit in cash depending on their election at the time of the merger. Primaris has been removed from How They Rate coverage.

Advice Changes

Colabor Group Inc (TSX: GCL, OTC: COLFF)–To Hold from Buy @ USD8. The food distributor posted underwhelming first-quarter financial and operating results, and progrees on management’s turnaround plan was negligible.

Most notably, comparable sales declined by 1.8 percent, and the payout ratio surged to 68 percent from 52 percent for the fourth quarter of 2012.

Encana Corp (TSX: ECA, NYSE: ECA)–To Buy @ 20 from Hold. The share price of Canada’s biggest natural gas producer has lagged surging commodity prices this year. This is for aggressive speculators only.

Extendicare Inc (TSX: EXE, OTC: EXETF)–To Hold from Buy @ USD8. Management of the senior care facilities operator announced a 42.8 percent dividend cut and also provided downbeat guidance for first-quarter numbers, as pressures in the US continue to mount.

Norbord Inc (TSX: NBD, OTC: NBRXF)–To Buy @ 30 from Hold. Improving conditions in the US housing market drove solid sales and earnings improvement during the first quarter, and management declared the company’s first dividend in four years. But this remains an aggressive bet.

Potash Corp of Saskatchewan (TSX: POT, NYSE: POT)–To Buy @ 42 from Hold. Management, after boosting the quarterly dividend 33 percent in January, reported solid operating results for the first quarter.

Ratings Changes

Extendicare Inc (TSX: EXE, OTC: EXETF)–To 2 from 3. The company loses a point for the dividend cut, and guidance for first-quarter numbers that will be released May 9 represents a significant negative turn from the fourth quarter of 2012.

Norbord Inc (TSX: NBD, OTC: NBRXF)–To 1 from 0. The oriented strand board manufacturer announced its first dividend in four years, as a recovering US housing market drove solid first-quarter results.

Safety Ratings

The core of my selection process is the six-point CE Safety Rating System, which awards one point for each of the following. A rating of “6” is the safest:

• Payout Ratio–A ratio below our proprietary industry baseline.
• Earnings Visibility–Earnings are predictable enough to forecast a payout ratio below our proprietary industry baseline.
• Debt-to-Assets Ratio–A ratio below our proprietary industry baseline.
• Short-Term Debt Ratio–Debt due in next two years is less than 10 percent of market capitalization.
• Business Stability–Companies that can sustain revenues during recessions are favored over more cyclical ones.
• Dividend History–No dividend cuts over the preceding five years.

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Resources

 

The following Resources may be found in the top navigation menu at www.CanadianEdge.com:

• Ask the Editor–We will reply to your queries via email or in an upcoming article.
• Broker Guide–Comparison of brokers for purchasing Canadian investments.
• Getting Started–Tour of the Canadian Edge website and service.
• Cross-Border Tax Guide–What you need to know about taxes and Canadian investments.
• Other Websites–Links to other websites to help you get the most out of your Canadian stocks.
• Promo Stocks–Guide to the mystery stocks we tease in our promotional messages.
• CE Safety Rating System–In-depth explanation of the proprietary ratings system and how to use it effectively.
• Special Reports–The most recent reports for new subscribers. The most current advice is always in your regular issue.
• Tips on DRIPs–Details for any dividend reinvestment plan offered by Canadian Edge Portfolio Holdings.