Algonquin slashed its distribution nearly 70 percent last October. At the time, my feeling was this was basically preparing for an early conversion. Management’s official statement was it was saving cash for growth.

As it turned out, both assertions proved true. Management has spent more on growth, most recently via a USD116 million 50-50 joint venture with Emera (TSX: EMA, OTC: EMRAF) to purchase the 47,000 customer California operations of NV Energy (NYSE: NVE). The dividend, meanwhile, was lowered enough to make it easily sustainable under a corporate structure.

Even counting Algonquin, “no-cut” conversions have been dramatically outnumbered by those involving reductions. Critically, however, market reaction to no-cut conversions has been highly favorable, particularly compared to conversions with dividend cuts.

I detect two clear reasons for this. One is investors like dividends. And while trusts that have cut during their conversions have eventually attracted more growth-focused investors, the cuts have initially triggered a disruptive mass exodus from their shares. That’s at least temporarily shut down their ability to raise equity capital at non-dilutive rates.

Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV), for example, eliminated its distribution in March as part of an early conversion to a corporation. And its CAD102 million equity sale in late June came off at just 60 percent of book value and less than half net asset value. The fact that it was forced to accept such a paltry sum is a real warning of weakness–i.e., that it truly needs cash–despite some recent recovery in the share price.

In contrast, trusts that have converted without cuts have seen their share prices rise immediately, as the cloud of 2011 uncertainty is removed. The new taxes they’ll face are more than offset by improved access to capital markets, thanks to a higher share price.

The other reason no-cut converters fare better is simply that being able to pay current dividends and absorb new taxes is a sign of strength in an otherwise still weak market. Canadian Edge has always focused on picking the trusts with the strongest underlying businesses rather than those paying the highest yields.

The main reason is the strong stand the best chance of growing over time, which is the best protection against credit risk and inflation that money can buy. Since the March 9 lows, we’ve seen time and again how quickly trusts and dividend paying corporations can recover, provided their underlying businesses are still solid.

And while we may be heading into a summer swoon in the markets, further recovery is definitely what lies ahead for our picks, provided they continue to generate strong earnings.

Now, however, there’s another compelling reason to stick only to the strongest trusts: They’re also the best candidates for no-cut conversions to corporations as 2011 taxation approaches.

As we’ve reported in CE’s weekly companion Maple Leaf Memo, the Liberal Party of Canada has basically drawn even with the ruling Conservatives in opinion polls. On the other hand, Liberal Party leaders appear in no mood to call for an election, given the Canadian economy’s weakness and the view in the country that government needs to have its act together.

It’s still possible we’ll see an election, a Liberal victory and the fulfillment of the party’s pledge to maintain trusts’ tax advantages in 2011 and beyond. And if it happens, trust investors will reap a windfall. But this is still a long shot that no one should count on.

The beauty of no-cut conversions, however, is we don’t have to count on change in the tax law. Trust managements can now see that if they can maintain current distributions as corporations, they’ll fare much better in the market place than if they slash their payouts in the name of growth.

The key again is to stick with good businesses. The Canadian economy has shown some signs of improvement since companies and trusts closed the books on the first quarter. That’s a good sign that businesses holding up to that point will have done so again in the second quarter. Conditions, however, are far from ideal, and we’re going to have to once again be vigilant and let the numbers be our guide.

Meanwhile, it’s more important than ever to continue to avoid businesses that are noticeably weak. Three more trusts cut distributions last month, but a lot of others are in growing danger of doing so. And even if they hold for the remainder of this recession, they’ll be in no position to keep paying out when they convert to corporations in 2011.

This is still a great time to buy trusts and high-yielding corporations backed by good businesses. In fact, any dip here due to general fears about the global economy makes them better buys. But this is also no time to be complacent. Sell the weak.

Portfolio Action

There are no changes to the Canadian Edge Portfolio this month. One reason is we’re waiting on second quarter numbers. Another is almost all of our picks have reported good news of some sort in recent weeks, most commonly by raising new equity and/or debt capital at very reasonable rates. The new funds will help reduce near-term debt and refinancing risk and they position our favorites both for weathering a continued downturn and for taking advantage of the recovery to come.

Note my advice is still for US investors to cash out of Sentry Select Canadian Income Fund (888-730-4623) and swap for EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF).

I’m keeping Consumers Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) as holds this month. We’re still waiting on key details from Ontario regulators pertaining to the future of Consumers’ Stratacon unit. Yellow, meanwhile, needs to show signs of stability in its second quarter numbers, though the recent debt refinancing is promising.

High Yield of the Month

Once again, this month’s High Yield of the Month entries are both on the conservative side: Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) and Just Energy Income Fund (TSX: JE-U, OTC: JUSTF). Both are deeply undervalued, have resisted the recession, bear high yields and are positioned for growth as the Canadian economy recovers.

As a REIT, Canadian Apartment is immune from 2011 taxation. Just Energy, meanwhile, has stated its intention to out grow its future tax obligation. Its efforts will be greatly aided by its large and very prosperous US operation, which is not subject to Canadian taxes.

How They Rate

How They Rate lists trusts and high-yielding corporations by the following sectors:

• 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.
• REITs–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. See the How They Rate Table for other changes in buy targets. Price and yield information is updated every 15 minutes in both the How They Rate and Portfolio tables. Use this service as a reality check when errors occur with US quotes-based services.

Note that it sometimes takes several days for a dividend cut to be updated in the live feed. All dividend cuts in our coverage universe are analyzed in detail in Dividend Watch List.

Column four of the table shows dividend frequency. Note that dividend dates shown are approximate and can vary within two to three days of listed date. 

This column also shows how each trust and corporation can reduce its tax burden in 2011. “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.

Note this month, we’re adding three Canadian natural resource corporations to How They Rate coverage:  Barrick Gold (TSX: ABX, NYSE: ABX), Cameco Corp (TSX: CCO, NYSE: CCJ) and Teck Resources (TSX: TCK/B, NYSE: TCK). All three are buys at prices listed in How They Rate.

I’m also dropping the following trusts that have broken under a dollar, have ceased to pay distributions and have rated sells for many months: Huntingdon REIT (TSX: HNT-U, OTC: HURSF) and SFK Pulp Fund (TSX: SFK-U, OTC: SFKUF). If you own them, dump them.

InnVest REIT (TSX: INN-U, IVRVF)–Hold to Sell. With the Canadian dollar strong and the US dollar weak, times are tough for the lodging industry.

Lanesborough REIT (TSX: LRT-U, OTC: LRTEF)–Hold to Sell. The suspension of the REIT’s distribution is a clear sign of deteriorating business conditions in oil sands country.

Newport Partners Income Fund (TSX: NPF-U, OTC: NWPIF)–Hold to Sell. With the holding company’s ability to meet debt interest payments in doubt, odds of recovery are dim.

Primary Energy Recycling (TSX: PRI-U, PYGYF)–Hold to Sell. The proposed recapitalization is worrisome for common unitholders, particularly now that distributions have been suspended.

Feature Article

Oil and gas get the headlines. But Canada’s natural resource bounty extends far beyond energy, from industrial and precious metals to vital agricultural inputs. Traditionally, the chief market for these raw materials has been the US. But that’s changing rapidly, with China emerging as an alternative market that’s even larger than the US for some resources.

We currently track 15 Canadian natural resource trusts and companies. I highlight the best of these, as well as a trio of new additions to How They Rate coverage. All are strong buys now, well off last summer’s highs and on track for big gains as the demand for and prices of their key commodity products soar in coming years.

Canadian Currents

In January 2006, Prime Minister Stephen Harper led the Conservative Party to a modest win over the long-entrenched Liberal Party, helming the smallest minority government in Canada’s history. He’s now served atop the longest-standing non-Liberal minority government since Confederation in 1867.

Setting aside the obviously contentious income trust tax fiasco, Mr. Harper has proved to be an aggressive, pragmatic leader capable of growing beyond ideological constraints. Granted, his growth may be more a reflection of his majority ambitions, but the prime minister has helmed Canada through the worst global economic crisis since the Great Depression, and he’s unquestionably a friend of business–and thus investors.

With new Liberal leader Michael Ignatieff looking more and more like the second coming of Stephane Dion, Mr. Harper could be the leader who makes the Conservatives Canada’s new “natural governing party.”

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–Three two Canadian trusts trimmed distributions last month: Lanesborough REIT (TSX: LRT-U, OTC: LRTEF), Primary Energy Recycling (TSX: PRI-U, PYGYF) and Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF). All remain highly challenged as businesses and rate sells, despite recent drops in price.

The rest of the Dividend Watch List (excluding oil and gas producers) includes: Big Rock Brewery Income Fund (TSX: BR-U, OTC: BRBMF), Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF), Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF), Essential Energy Services (TSX: ESN-U, OTC: EEYUF), FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF), InnVest REIT (TSX: INN-U, OTC: IVRVF), Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF), Noranda Income Fund (TSX: NIF-U, OTC: NNDIF) and Primaris REIT (TSX: PMZ-U, OTC: PMZFF).

For advice on all of these trusts and companies, see the How They Rate Table.

Bay Street Beat–The word from the Canadian analyst community, including its views on our favorite trusts, notable research, and emerging trends.

Spirit of Cooperation–Under a draft proposal distributed by Canada’s Competition Bureau, an independent agency, firms would no longer face criminal conspiracy charges for cooperating on the construction of new megaprojects.

This means Canada’s energy giants could be allowed to consult each other on new oil sands projects, a key change that would give them greater purchasing power to help prevent cost overruns and speed construction timelines.

Convention Changes–A recent amendment to the US-Canada Income Tax Convention changes the amount of withholding from distributions by companies classified as partnerships for US federal tax purposes. While the Fifth Protocol has aroused some confusion, its implications are limited within the context of the CE coverage universe.

More Information

The following is a regular repeat from prior issues.

Use our live quote feed in How They Rate for intraday US dollar prices and yields for trusts and high-yielding corporations. 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 http://www.adviceforinvestors.com/, the Web site of our Canadian partner, Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8). The site features 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 the US 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 Income Trust Tax Guide has backup to file distributions as “qualified dividends.”

Roger S. Conrad
Editor, Canadian Edge