Canadian trusts and high-yielding corporations picked up in August where they left off in July. The broad-based S&P/Toronto Stock Exchange Income Trust Index surged to highs not seen in more than a year.

Meanwhile, the Canadian dollar settled into a new range of around USD0.91, further lifting the US dollar value of dividends.

Unfortunately, September has opened in an entirely different way. Conventional wisdom seems to be the rally that began in early March has been overdone. As the theory goes, stocks across the board already reflect too much good news that hasn’t yet happened, and are therefore increasingly vulnerable to at best a wicked pullback, at worst another bear market down leg.

There’s little doubt at least some sectors are vulnerable now. Stocks whose fortunes are most closely tied to the economy’s health have been highly popular this summer, despite generating relatively little good news on the business front.

That particularly applies to energy producers, which have seemed to track every up and down in the economic data. Natural gas is already at its lowest level in years. And several weeks of setbacks for the global economy could certainly take oil down hard as well.

The key question for investors, however, is whether today’s risks are comparable to what the markets faced a year ago: the near-failure of the global financial system and the freezing up of credit. If they are, it makes sense to abandon positions even in companies and trusts that have held up for what’s now a 26-month-old bear market/recession.

If they aren’t, however, the best course is to stick with what you have provided the underlying businesses are still generating healthy numbers. And that, happily, remains the case for Canadian Edge Portfolio members.

It’s Not 2008

Today’s risks, although severe for some, don’t come anywhere close to matching those of a year ago, at least for well-run, low-debt trusts and high-yielding corporations. Simply speaking, this isn’t September 2008.

Exhibit A is the vastly improved health of the credit markets. Even in the darkest days of the global financial meltdown, maintaining access to credit was never a serious challenge for Portfolio members. Today, however, even economically sensitive holdings are getting credit on favorable enough terms to cut interest expense.

Income trusts’ ability to issue equity has been constrained by “safe harbor” rules since late 2006. But what they can issue is being snapped up at the most robust rate since the prospective 2011 trust tax was announced.

In the all-important natural resources sector, 10 oil and gas producers have announced significant acquisitions since early summer. Their ranks include natural gas-focused producers like High Yield of the Month Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), despite the fact that gas prices are in free-fall now.

Moreover, the recent major investment from China in the oil sands is a pretty good sign that even the most aggressive Canadian acquirers are very much in play themselves.

The country’s banks reported solid second quarter results despite higher loan losses. That’s a good indication this bedrock of the economy is sound after two years of setbacks, even as Canada’s central bank has described the country’s recession as “ending.”

Businesses that rely on sales to heavy industry are still floundering, as last month’s dividend cut by Wajax Income Fund (TSX: WJX-U, OTC: WJXFF) attests. Anything connected to the US housing market–from construction materials to forestry–is similarly flat on its back.

The energy services sector is an outright disaster, as natural gas inventories overflow storage facilities and the rig count is down more than 70 percent in many areas. And as is the case in the US, we’ve seen several retail bankruptcies as tapped-out consumers have pulled in their spending, hitting both that sector and the owners of the shopping malls that lease space to them.

If the economic news does come out as some fear, it’s not hard to envision companies and trusts in these sectors giving back much of the ground they’ve gained in recent months. And after the catastrophe of last September/October, it’s little wonder that at least some investors are taking their money off the table.

There are also several potential catalysts for a substantial general selloff in stocks. For one thing, even rallies in good times have to take an occasional breather, as share prices outrun prospects, and this one has been more or less in progress since early March.

Values in commercial real estate have been falling for some months in many parts of North America in the face of rising vacancies and falling rents. A mass default in loans would put further pressure on the banking system, and we have already seen the collapse of several highly indebted Canadian REITs.

The selloff in China’s stock market has raised fears of an unexpected slowdown in that country. That could have particular implications for Canada, which had deepened its trade relationship greatly in recent years.

Finally, there’s always the possibility of some catastrophic event sending investors scurrying for the exits.

None of these potential catalysts are on par with what happened in late 2008. Events like last year’s credit market meltdown are thankfully rare, as they combine devastating economic consequences with the element of surprise. These risks aren’t nearly as far-reaching or systemic. Moreover, they’re hardly unexpected, either by the investment public or the global monetary authorities charged with heading them off.

That’s not to say a crash in Chinese stocks or a sharp rise in office vacancies couldn’t do real damage, particularly in the near term. In fact, it’s not inconceivable that the Dow Industrials and S&P 500 could well retest their lows of earlier this year if investors get spooked enough. And Canadian investments would hardly be spared under those conditions.

But there’s nothing now to compare with the broad systemic risk that freezing credit markets posed last year. And the credit markets, while shut to the revenue-poor and debt-heavy, are open for business again.

Even the US banks that continue to fail are being seized and systematically disposed of by the Federal Deposit Insurance Corporation (FDIC), which is no longer having a problem finding buyers for distressed assets. The system is far from healthy, but neither is it teetering on the abyss anymore. And as long as that’s the case, there’s just no potential for the kind of complete disaster that struck in late 2008.

Strong Earnings

That’s Exhibit A. Exhibit B is simply that earnings for my favorite we saw in the second quarter of 2009, amid arguably the worst economic conditions in North America in decades.

True, many companies continued to stumble, particularly those that piled on the debt during the good times. But those trusts and companies that had been doing well since this recession/bear market began in mid-2008 also did well in second quarter 2009.

Moreover, even many companies and trusts that had been hit hard by the weak economy demonstrated that they are navigating their way through these tough times. Conditions took their toll on headline earnings, but only within guidance as management offset their effect with cost cutting and debt reduction.

And for most, the dividend cuts made earlier in the year in response to reduced forecasts have proven to be more than enough to safeguard both financial health and future growth prospects, as well as ensure reduced dividend levels.

This was not just good news for the second quarter of 2009. It’s the best possible news that these companies and trusts are well-positioned for the rest of the year and beyond, whether the economic recovery comes sooner or later.

Then there’s the question of value. Share prices have rallied sharply off the lows of early March. But yields are still high and prices continue to discount plenty of bad news that’s increasingly unlikely to happen.

As long as underlying business fundamentals are sound, that means extreme values and substantial upside from here, though we may have to be patient to collect on it.

This is certainly the case with Portfolio picks, only two of which currently rate holds, Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) and Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF).

For Yellow, second quarter 2009 earnings did support the distribution by a comfortable margin. My question, however, remains whether the management guidance given with its first quarter 2009 earnings–when it elected to cut its distribution–is still holding, or if conditions have worsened more than it expected. If it’s the former, the distribution is safe. If it’s the latter, the distribution is still at risk.

Second quarter numbers appear to indicate guidance is holding. That’s certainly what management claimed in its second quarter conference call. And in fact, distributable cash flow per share was actually flat versus year-earlier levels, as cost-cutting and Internet-based growth at the core directory business offset continued weakness in real estate and automobile advertising. The current dividend payout ratio is only 57 percent and the company began taking steps to get its debt under control before converting to a corporation in 2011.

The challenge now is whether or not third quarter numbers will show the same progress. If so, the current level of distribution can be inferred as solid, even after 2011 taxation kicks in. That’s still my expectation and, if that proves the case, the shares will easily double from here.

But until those numbers do come in, I’m not recommending fresh buys of Yellow. If you’ve bought this one on my numerous recommendations of recent years, there’s no need to load up on more. Yellow Pages Income Fund is a hold.

As for Consumers’, as reported in an August 24 Flash Alert, it’s received a decision on its appeal of a ruling by Ontario regulators concerning its Stratacon sub-metering business.

The new ruling will allow the company to operate that business, though it will now be required to jump through a few more regulatory hoops. It will, for example, no longer be able to ink deals directly with landlords, unless those property owners first ask the permission of their tenants to install smart meters.

On the bright side, Consumers’ says it will only have to ask permission from about 1 percent of current customers. But the new rules could make it more difficult to grow the business as rapidly as the trust wants.

The shares are definitely pricing in a hefty dividend cut, which Consumers’ may do to prepare for 2011 taxation if it feels Stratacon won’t live up to its prior growth projections.

The good news is it’s difficult to envision a cut larger than the 50 percent-plus that Consumers’ shares are now apparently pricing in. And anything less is bound to trigger a sharp rebound in the shares. But again, until this situation is clarified, I don’t advise taking additional positions. Hold Consumers’ Waterheater Income Fund.

On a more encouraging note, if we’ve learned anything over the past half year it’s that even the hardest hit stocks can recover, so long as the underlying business is still solid.

For example, Newalta (TSX: NAL, OTC: NWLTF) has risen nearly four-fold off its early March lows.

And that move has been almost solely due to a single analyst upgrade in the wake of what appeared to be stabilizing second quarter earnings.

Once the recycling/cleanup business it dominates really begins to recover, I look for a return trip to USD20 and higher. 

Portfolio Watch

In the August CE I reviewed roughly half the Portfolio’s earnings. I highlighted the other half in an August 13 Flash Alert. Below, I take a deeper look at those numbers.

As was the case for the trusts and companies that released earnings prior to the publication of the August issue, all of those tracked below measured up to the task of remaining strong companies in the second quarter. That’s the best possible assurance they’ll continue to perform in the third quarter and beyond, and the best possible reason to own them going forward.

Note that I recommend two ways for new investors to get involved with CE recommendations. Strategy one is to simply buy the High Yield of the Month selections from each issue until you’ve built a portfolio of eight to 10 holdings over a period of months.

Strategy two is to pick out eight to 10 holdings depending on your risk tolerance–Conservative Holdings are best for income investors seeking the least risk–and buy in three increments over time.

Here’s my analysis of the recommendations. Note that results of energy producers are discussed in this month’s feature article.

Conservative Holdings

Artis REIT’s (TSX: AX-U, OTC: ARESF) focus on the Canadian energy patch made it a good candidate for a setback in the second quarter. In fact, several rivals in the region have already scrapped or cut dividends, as aggressive expansion projects and heavy debt hit the brick wall of the economic slowdown.

Artis hasn’t been wholly immune from the troubles. But the REIT’s focus on smaller tenants and quality properties with below-market rents has kept it on solid ground.

Revenue rose 3.4 percent to a record CAD35.5 million, while net operating income moved up 5.5 percent.

Occupancy actually rose to 96.2 percent, and management was able to boost rents on expiring leases by 8.1 percent.

Debt of 51.2 percent of gross book value is well below the 60 percent allowed by lender covenants and reflects management’s commitment to maintaining a strong balance sheet come what may.

As long as the oil patch economy stays weak, Artis’ growth will remain subdued and well below the double-digit rates routinely recorded in recent quarters.

On the other hand, the yield of 12 percent is well covered by the payout ratio of just 68 percent, and the REIT is managing its risk in this environment.

Note that because it’s a REIT Artis is exempt from 2011 taxation. Shares have come well back from their lows, but Artis REIT is still a buy up to USD10.

Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) is also exempt from 2011 taxation; it actually trades as an Income Participating Security (IPS), which combines common stock with debt. Atlantic’s pays a coupon interest rate of 11 percent and is slated to mature in 2015.

At that time, Atlantic will have several options to pay off the bond portion of the IPS, including refinancing it with US dollar debt to reduce the currency risk from its US-based revenue stream.

Investors will receive the principal of CAD5.767 per unit in cash, leaving them with a high-yielding stock paying roughly the same as the full security does now. Management has been systematically reducing its refinancing risk with share buybacks over the past year.

Of course, Atlantic’s real appeal is the strength of its underlying business, which consists of stakes in 14 power plants and the Path 15 powerline linking Northern and Southern California. Management won a solid rate agreement for Path 15 with the Federal Energy Regulatory Commission, securing a robust rate of return of 13.5 percent.

As for overall cash flow, management again demonstrated its ability to eliminate uncontrollable influences on profits, such as economic growth, energy prices and currency swings. Cash flows rose at some projects and fell at others, but the overall second quarter payout ratio came in at just 68 percent and 71 percent for the first six months of 2009. Those are the lowest rates in company history.

Management has affirmed existing projects can support the current monthly distribution at least through 2015, when the debt portion of the IPS matures. That objective was furthered last month with the successful sale of a Georgia power plant for cash. Still yielding more than 12 percent, Atlantic Power Corp is a buy up to USD10.

Bird Construction Income Fund’s (TSX: BDT-U, OTC: BIRDF) strong second quarter  numbers were little surprise, as they reflect the robust backlog of construction jobs management has built up in recent years. The high credit quality of customers has ensured these ongoing projects have continued and that bills have been paid.

Second quarter earnings per unit hit CAD1.13, up from CAD0.97 a year ago. The payout ratio sank to just 40 percent, leaving plenty of room for Bird to convert to a corporation without cutting dividends.

What has been something of a surprise, however, is the way Bird has been able to tack with current market conditions, rebuilding its order backlog despite the toughest market environment in memory.

In late August, Bird announced a new contract to build a major industrial building for Potash Corp of Saskatchewan (TSX: POT, NYSE: POT) and another to construct two schools in Atlantic Canada.

These are the latest signs the company is tapping into the infrastructure boom funded in large part by Canadian government stimulus.

Robust growth won’t return until the Canadian economy rebounds, particularly the energy patch. But with no debt, a huge cash pile and still-abundant new business, Bird is weathering this tough environment. The shares have surged this year, but there’s still plenty of upside for those who buy Bird Construction Income Fund below USD30.

Canadian Apartment Properties REIT’s (TSX: CAR-U, OTC: CDPYF) long-held strategy of investing only in high-quality markets and with extremely conservative financing has paid off in every prior recession in the REIT’s history, and this one is proving to be no exception.

Canada’s residential real estate market has softened, but you wouldn’t know that from looking at Canadian Apartment Properties’ second quarter results, which actually showed faster growth from prior quarters.

Occupancy remained steady at a stellar 97.2 percent, rents grew 1.1 percent portfolio-wide, expenses were reduced to barely 43 percent of revenue and cash flow coverage of interest actually rose. Even the Alberta properties (5 percent of cash flow) are still performing. Overall revenue rose 3.8 percent, while distributable income per share ticked up 4.2 percent.

As I’ve said in the past, this is a conservative REIT. No one should expect to see rapid growth, even in boom times. But the payout ratio of just 78 percent is a clear sign the dividend of around 8 percent is safe and is likely to grow again when conditions improve. Buy Canadian Apartment Properties REIT up to USD15.

CML Healthcare Income Fund’s (TSX: CLC-U, OTC: CMHIF) core medical imaging and diagnostic testing business again proved itself recession-resistant in the second quarter of 2009, both in Canada where it’s dominant and in the US where it’s building a presence in advance of Obama Care.

Testing could get a major lift here as health insurance rolls grow from government initiatives, as well as from the automation of information to cut costs. And revenue is secured by cash flow from health insurers and government.

That demand for medical services is inelastic is no great surprise. But even in that context, CML’s steady numbers in both Canada and in the US are exemplary.

Revenue rose 12.9 percent in the quarter and the payout ratio was steady at 90 percent. Cash flow margins rose to 15.3 percent from 14.2 percent a year, indicating growth is paying off and management is effective cutting costs.

There’s still some uncertainty about what CML will do in 2011 when it faces new taxation. To date, management’s only statement on the issue has been to affirm it doesn’t intend to convert before it has to.

But insiders and Bay Street are still bullish, and the distribution looks secure for now. Note that income from the US operations is exempt from the new tax. Buy CML Healthcare Income Fund if you haven’t yet up to USD13.

Innergex Power Income Fund (TSX: IEF-U, OTC: INGRF) is attractive on several levels. First, its portfolio of hydro and wind power plants continues to turn in strong results.

The second quarter payout ratio came down to 87 percent on a 5 percent jump in revenue, as plant expansions offset the impact of less favorable weather. Wind output was 31 percent higher than last year, reflecting growth, while a maintenance related shutdown at three plants crimped hydro output. That should reverse in coming quarters, to the benefit of income.

The trust’s second quarter payout ratio came in at just 78 percent, the lowest ever. That’s a terrific sign for dividend safety up until and beyond 2011, when the trust will face new taxes.

Second, there’s also the potential for a high-premium takeover, with numerous North American coal plant owners the most likely suitors due to the trust’s ability to generate carbon credits with its growing clean energy portfolio. A deal should fetch a price at least 30 percent above current levels. Yielding 10 percent, Innergex Power Income Fund is a buy up to USD12.

Northern Property REIT (TSX: NPR-U, OTC: NPRUF) has also been hit by Canada’s economic slump. Apartment holdings in areas where the economy is dependent on oil and gas output have taken a particular hit, due to a “sharp increase in residential vacancy.”

The good news is that’s not a major part of the REIT’s overall business. In fact, the weakness was again more than offset by strong growth in other geographic areas such as the Far North and Newfoundland where the REIT is in many cases the only game in town.

Management’s reliance on government customers has also paid off with low defaults and forced vacancies portfolio-wide, holding overall portfolio vacancy to just 4.1 percent (95.9 percent occupancy).

The result: An overall 8.1 percent jump in its distributable cash flow per share. That drove the payout ratio down to just 66 percent, one of the lowest in the industry and setting the stage for robust growth as the Canadian economy finally turns.

Again, that’s a testament to management’s conservative focus, controlling debt and strategy of signing on only the most creditworthy of tenants. And it’s a good sign going forward for the 7.3 percent yield. As a REIT, there will be no additional taxes in 2011 and beyond. Buy Northern Property REIT up to USD20.

Aggressive Holdings

Ag Growth International (TSX: AFN, OTC: AGGZF) turned in another solid set of numbers in the second quarter, during a month of which it operated as a corporation after converting in early June. Ag Growth elected to convert without changing its distribution. That decision was firmly backed up by its operating results.

Revenue jumped 19 percent, combining with cost controls to produce a 61 percent surge in cash flow and a 121 percent upward burst in earnings per share, now the primary marker for gauging dividend safety for Ag. The second quarter payout ratio came in at 40 percent, the latest evidence that this company has been able to absorb its new tax burden with plenty of room to spare.

The real keys to Ag Growth’s success are management’s successful expansion of capacity over the past couple of years and continued robust demand for North American corn.

Even as a recession has gripped demand and prices for many agricultural commodities, the combined impact of global food demand and ethanol mandates at home have kept American corn planting strong.

In fact, indications are 2009 will mark the highest corn acreage planted in US history. That adds up to continued robust demand for the company’s portable grain handling equipment.

Ag Growth has handed us a windfall gain since its election to convert without cutting dividends. Shares are now up more than 80 percent this year and 20 percent over the past 12 months, so gains from here will depend solely on management’s ability to deliver on growth.

Fortunately, the numbers give us every indication of further gains ahead. Buy Ag Growth International if you haven’t already up to USD30.

Newalta (TSX: NAL, OTC: NWLTF) was easy to leave for dead this spring. The company’s core environmental cleanup business had already taken hits for many months, as slowed drilling activity in Canada’s energy patch diminished the need for services and falling energy prices cut revenue from recycled products. Even the rapid expansion into the industrial east had hit a wall, as North America’s economic meltdown shuttered activity.

Then came its ill-timed conversion to a corporation and an accompanying dividend cut. The move made perfect sense from a business standpoint–save cash, foster expansion–but came at a time when investors were ill-disposed to absorb another distribution cut. The shares touched a late-March low of barely USD2, fully 93 percent off the Oct. 20, 2006, high of USD30.06.

Since March, however, Newalta shares have surged nearly four-fold. The obvious catalyst has been value hunters but ultimately the key has been management has never lost its focus, despite extraordinarily tough times.

The company has maintained its strategy of building a leading national franchise for cleaning up industrial sites and recycling waste, including the most recent initiative into the oil sands region.

It’s also continued to focus on keeping costs down and paying off debt, ensuring solvency during the bad times.

That’s stuff powerful recoveries are made of and, while it may take time, it’s what I look for with Newalta.

Do I wish I had never recommended Newalta in 2005? Absolutely, and had I been able to predict the total and simultaneous meltdown in Canada’s energy patch and industrial heartland, I would never have stuck with it.

The point is, however, that this company has weathered this crushing depression in its sector and is more focused than ever on long-term growth. Moreover, the potential of its market is, if anything, greater than ever, given the increasing global focus on using resources wisely and cleaning up waste.

Despite their recent bounce, the shares still trade at just 69 percent of book value and 64 percent of sales. That leaves a lot of room for upside. We’re not likely to see it until economic conditions do pick up in North America. But anyone who’s held Newalta this long has no excuse for selling now. Meanwhile, I’m raising my buy target on Newalta for patient speculators up to USD10.

Trinidad Drilling (TSX: TDG, OTC: TDGCF) is in many ways a twin of fellow Aggressive Holding Newalta. The company initially attracted me because of management’s considered and successful strategy of focusing on deep drilling in the US and signing on only the most creditworthy producers under long-term contracts.

Like all drillers, Trinidad has been hit hard by falling rig utilization rates in North America. But it’s been able to stick to its strategy of steadily building out and improving its rig fleet, with a recent foray into Mexico proving particularly successful.

Despite sharply lower utilization, the company still covered its dividend with earnings in the quarter (the payout ratio was 56 percent after one-time items), and management pointed to signs of stabilization in its market.

Gross margin actually improved to 42 percent, as management was able to offset at least some of the revenue shortfall with cost controls. Those are good numbers in a tough environment and point to huge recovery potential going forward.

Unlike Newalta, Trinidad effectively timed its conversion to a corporation. Thanks to the early 2008 surge in energy prices, shares had roughly doubled by early summer, giving investors what in retrospect was a super time to cash out.

For those of you who did, kudos. For the rest of us, however, the worst is behind us with this one and the upside potential is immense.

The company trades at just 71 cents on the per dollar value of its state-of-the-art rig fleet and just 75 percent of what are now very depressed sales.

The yield of 3.6 percent ranks among the highest of any driller, most of which have stopped paying distributions altogether.

It may be a while–or never–before Trinidad shares again revisit their all-time high of USD19, hit at the peak of the North American drilling boom in February 2006. What we do know, however, is this is a survivor that’s extremely leveraged to a sector recovery and well positioned to survive whatever is left of this energy patch depression.