Despite an inauspicious beginning, 2009 turned out to be a banner year for the Canadian Edge Portfolio, with the Conservative Holdings returning 65 percent and the Aggressive Holdings 66 percent.

Getting there wasn’t easy. For one thing, we had to hang in during a traumatic first quarter, which immediately followed the market’s once-in-a-generation meltdown in late 2008. We were also hit with more than a few distribution cuts, particularly by oil and gas producer trusts whose cash flows shriveled in the face of plummeting energy prices.

The really good news as we move into 2010 is we can expect more happy returns. Reason No. 1 is the stress tests behind both the selloff and the distribution cuts are fast fading in the rearview mirror.

As we’ve pointed out in CE’s weekly companion Maple Leaf Memo, the Canadian economy is gaining strength much faster than the US.

The country’s resource-export relationship with developing Asia is expanding. Coupled with revived US demand, most recently seen in the fourth quarter recovery of industrial output, this budding trade augurs well for energy prices in coming months.

That’s a great reason to expect big gains for solid oil and gas producers, most of which are still trading well below the value of their assets in the ground. And it’s bullish for the Canadian dollar as well, which means a higher US dollar value for shares and dividends.

Unlike in the US, credit was never a problem for Canada during the crisis, thanks to much more conservative banking practices. Canadian banks’ recent acquisitions of foreign assets and the flood of convertible security issues from Canadian companies are two good signs that money is flowing. And more than a few companies are issuing equity once more to fuel expansion.

Since CE’s inception in mid-2004, we’ve stressed the value of healthy and growing underlying businesses, as opposed to simply chasing the highest yields. That approach didn’t save us from the volatility that began in mid-2007. But it did keep us in the game for the recovery that began in March 2009–and we’ve snared some very generous and reliable dividends along the way.

Looking ahead, buying the business is still the key to building wealth in Canada, just as it is everywhere else. Thanks to the North American economic recovery, the brightening outlook for energy prices, and much-eased access to capital markets, the number of real business disasters should continue to diminish. There’s even hope for recovery from some of the basket cases of the past few years.

There’s also one major potential fault line in 2010 between well-run businesses and weaklings, whose only appeal is a high yield to lure the unwary. That’s the wave of trust conversions to corporations, which is likely to accelerate sharply as the weather warms.

There’s no doubt trust managements have a clear incentive to preserve as much of their dividends as possible when they convert: a lower cost of capital.

When the first conversions were made, most trust managements were under the delusion that their companies could grow faster by hoarding more cash flow–i.e. slashing dividends and blaming it on the Canadian government. What they didn’t consider enough was the sharply negative impact on their post-conversion share prices, which made issuing equity prohibitively expensive. That, in turn, increased dependence on credit markets, which, thankfully, most did not over-access in the run-up to the late 2008 freeze.

In contrast, converting trusts that haven’t cut dividends–or that cut less than expected–have seen their shares surge. They’ve had less operating cash flow to allocate to growth, particularly as they’ve absorbed new taxes. But they’ve been able to raise capital far more cheaply. And they’ve grown revenue and earnings much faster than they would have by relying on operating cash flow alone to fund capital spending.

Last month, two more trusts in the CE universe announced conversions. The stronger–fuel distributor Parkland Income Fund (TSX: PKI-U, OTC: PKIUF)–pledged no change to its dividend. But Trilogy Energy Trust (TSX: TET-U, OTC: TETFF) also beat expectations by preserving 70 percent of its payout, despite still facing tough conditions as a small natural gas producer. Both are up solidly in advance of conversions scheduled to take place by early February.

The chief risk of 2010 is that not every trust has the business strength to pay even close to the same distribution after converting. The best way to ensure you’re with the winners is to focus on the best businesses–and that’s always been our primary goal at Canadian Edge.

Finally, a word of welcome for new readers who joined us after last month’s Audio Conference, “The Great Canadian Windfall of 2010,” which is now posted along with answers to submitted questions on the website; click on “Events” in the navigation bar above. Also, a word of advice: This section, “In Brief,” is the executive summary of what’s in the rest of the issue. It’s the first section of Canadian Edge you’ll want to read every month.

If you have questions about anything related to CE, please drop us a line by clicking on the “Contact Us” item in the top-right corner of the page.

Portfolio Action

Investors came back to quality in the latter half of 2009, and that made it a good year for our Conservative Holdings. Aggressive Holdings, meanwhile, benefited mainly from reviving commodity prices.

All of our picks, however, owed their positive ride to their ability to weather even the most difficult of market conditions. And that’s the best possible reason to stick with them as we enter a year where promise far outweighs danger, but which still carries substantial risks.

There are no changes to either the Conservative or Aggressive holdings this month, but I do have one cautionary note: Many of the picks have moved very close to my buy targets, the maximum price were I deem it a value based on the strength of its underlying business. I may indeed raise some of these targets as the year progresses, but only if there’s a compelling reason that justifies the higher price. In the meantime, new buying is best concentrated in the recommendations trading below my targets.

For new investors, I recommend two strategies for building a portfolio of Canadian trusts and high-yielding corporations. The easiest is to take full positions in the two High Yield of the Month picks each month until you reach your desired number of holdings.

The other method is to pick eight to 10 recommendations–yield-seekers should focus mostly on the Conservative Holdings–and buy in increments. One example would be a third now, a third in a month and the final third a month after that.

This month’s Portfolio Update highlights developments at a number of Conservative Holdings as well as how recommendations stand on trust conversions. I also list expected dates for the next round of earnings reports, which I’ll be analyzing extensively in the February CE, subsequent Flash Alerts and the weekly Maple Leaf Memo.

High Yield of the Month

January’s High Yield of the Month selections have been Canadian Edge Portfolio holdings for some months. Both, however, have undergone major transformations in recent months.

Conservative Holding Atlantic Power Corp (TSX: ATP, OTC: ATLIF) has converted to a corporation from an income participating security (IPS). It’s also on the verge of a potential new wave of growth, as management lists on the New York Stock Exchange (NYSE) later this year.

The other pick is Blue Ribbon Income Fund (TSX: RBN-U, OTC: BLUBF), the product of a merger of a eight funds in the Citadel Group of Funds, including the former Series S-1 Income Fund. The larger fund should be able to run much more efficiently due to greater scale. It’s also loaded with CE energy industry recommendations, such as ARC Energy Trust (TSX: AET-U, AETUF) and Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF).

The conversion ratio for Series holders was 0.770898 units of Blue Ribbon per unit of Series. The merger was completed on Dec. 31, 2009, and Blue Ribbon units should by now have shown up in accounts. Accordingly, Series has been delisted.

How They Rate

This month’s How They Rate includes a few changes. First, we’ve changed our quote system, a step that should make price and dividend information more accurate. Dividend dates are now automatically updated from the same source.

I’ve also replaced information on share issue growth with the updated debt-to-equity ratio. The latter is now much more significant with trusts converting to corporations, rendering limits on new share capital basically moot.

Finally, note that information on trust conversions is now included in a separate table, featured in this month’s Tips on Trusts and in the Income Trust Tax Guide. We’ll be updating this information regularly as new conversions are announced. Information on US taxation of How They Rate companies will now be included in the table on a regular basis.

I list 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 How They Rate for other 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.

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.

Bellatrix Exploration Ltd (TSX: BXE, OTC: BLLXF)–Hold. Bellatrix pays no dividend, and so isn’t appropriate for income investors. It’s heavy on natural gas, however, and has enough appeal as a possible takeover target to rate a hold. There are far better gas plays, though.

EnCana Corp (TSX: ECA, NYSE: ECA)–Hold to Buy @ 40. The spinoff of the company’s oil operations is now complete. What’s left is one of North America’s premier gas companies, particularly in the non-conventional plays that are increasingly the most economic. The Canadian government could put up road blocks to a takeover, but EnCana is an extremely valuable property and isn’t expensive, either.

Harvest Energy Trust (TSX: HTE-U, NYSE: HTE)–Acquired. Korea National Oil Company closed its takeover of Harvest on Dec. 23, 2009. The CAD10 per share all-cash deal wasn’t subject to Canadian withholding, and the full converted amount of USD9.50 or so per share should by now have shown up in investors’ accounts.

Imvescor Restaurant Group (TSX: IRG, OTC: IRGIF)–Sell to Hold. Management has beaten my expectations with a post-merger/conversion dividend of 7.5 cents Canadian per quarter. Best of all, it looks sustainable, even in a tough market for restaurants.

Peak Energy Services Trust (TSX: PES-U, OTC: PKGFF)–Hold to Sell. Anytime a company in a collapsed industry borrows at a rate of 18 percent, it’s not a good sign.

Progress Energy Resources (TSX: PRQ, OTC: PRQNF)–Hold to Buy @ 15. The awakening of the North American natural gas industry puts this company back on my radar. The key risk is heavy debt but production continues to rise rapidly.

TransAlta Corp (TSX: TA, NYSE: TAC)–Hold to Buy @ 22. This is a solid company and the future looks brighter for power demand in North America, including Western Canada.

Trilogy Energy Trust (TSX: TET-U, OTC: TETFF)–Hold to Buy @ 10. Management’s announced conversion to a corporation was far more benign for unitholders than I’d expected, given tough conditions for natural gas producers. This gas-focused company is also takeover target, particularly when the conversion happens, probably in early February.

Feature Article

Oil and gas producer trusts have gone from boom to bust and back again several times over the past few years. The good news is the recovery that began in early 2009 should continue this year, as energy prices stay strong, trusts beat expectations for post-conversion dividends, and takeover activity heats up in North America.

Pickings are particularly good in the battered natural gas sector, where Super Oils are showing increasing interest. Here are the best picks.

Canadian Currents

All but forgotten amid Washington’s raging health care debate is the fate of preferential investment tax rates, enacted in the early years of the Bush administration. CE Associate Editor David Dittman has some surprisingly good news on this critical issue.

And an important new interpretation of the US-Canada Income Tax Convention has important implications for investors, IRAs and income and royalty trusts.

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 How They Rate companies cut their payouts last month. One was actually not a cut at all, but the result of the spin off of EnCana’s oil producing operations as Cenovus Energy (TSX: CVE, NYSE: CVE). The two companies combined still pay the former rate of CAD0.40 per quarter.

Trilogy Energy Trust’s 30 percent reduction was billed as part-and-parcel of its decision to convert to a corporation ahead of 2011 trust taxation. In reality, slumping natural gas prices probably played just as big a role in the move, making the producer’s decision to keep 70 percent of the payout a very pro-shareholder move.

Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF) trimmed its payout for the second time in two years, by roughly 43 percent. The good news is the move was well anticipated by the market, as the units have risen since. Also, management anticipates it will be sustainable after 2011 taxes kick in, even if timber market conditions stay weak.

I report on prospects for all three companies as well as those of FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF), which has a new credit agreement that places limits on how much it can pay out in distributions.

The rest of the Dividend Watch List (excluding oil and gas producers) includes Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF), InnVest REIT (TSX: INN-U, OTC: IVRVF), and Primaris REIT (TSX: PMZ-U, OTC: PMZFF). DWL reviews the cutters.

All are tracked in How They Rate. Energy producers’ distributions by nature rise and fall with energy prices and are technically therefore always at risk.

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

Thank You, Vanguard–Popular brokerage Vanguard has managed to force its clearing corporation to withhold Canadian investment dividends at the proper rate of 15 percent.

Collecting Convertibles–A number of Canadian trusts and high yielding corporations are issuing convertible bonds. Interest paid is not withheld by Canadian authorities and, as long as you buy only from strong businesses, there’s upside as well. The trouble is finding a broker who will sell them to you. We look at the ins and outs.

How They Rate for 2011–Here’s a company-by-company look, in table form, at how the How They Rate universe is approaching 2011 taxation.

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 www.AdviceforInvestors.com, the website 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 website for a range of information on income and royalty trusts.

The Web site 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 website 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