Thirty-one Canadian companies have now completed their conversions from income trusts to corporations. The average total return since their announcements: a bullish 45.3 percent.

That kind of performance will surely come as a surprise to the legions of investors and their advisors who gave up on trusts after Halloween night 2006. That’s when Canada’s Conservative Party government did an abrupt about face and announced a new tax on trusts starting in 2011.

The announcement of the tax triggered a haircut of more than CAD20 billion in income trusts–then more than 250 strong–in the weeks that followed. But it also did something else infinitely more important for investor returns.

Mainly, it enforced a discipline on a sector that had grown wildly during the boom, from which only the heartiest would emerge. The private capital takeover binge of early 2007 enabled some four dozen trusts in the Canadian Edge universe to take the easy way out via profitable buyouts. Mergers between trusts also surged, as smaller companies became stronger with scale.

The result was a dramatic thinning of the ranks by the time the Great Crash and Credit Crunch of 2008 hit home. For US investors, Canadian stocks of all stripes were among the worst hit income sectors that year, as market losses were compounded by the slide in the Canadian dollar.

Spooked by the specter of 2011 taxation, many investors were wholly unaware that the broad-based S&P/Toronto Stock Exchange Income Trust Index (SPRTCM) made a new all-time high in May 2008 as energy prices exploded upward. But by March 2009 the SPRTCM was at barely one-third that level in US dollar terms. Yields in the low teens and higher were commonplace, though few wanted to go near them.

Ironically, the remaining trusts had just provided the most compelling proof possible of their long-term viability and wealth-building potential. The crash was the last straw for the weaklings, many of which had been cobbled together during the boom to take advantage of the trust structure and demand for yield to raise capital.

The survivors, however, had proved they could weather the worst possible conditions as businesses. Some, like Atlantic Power Corp (TSX: ATP, OTC: ATLIF), actually raised dividends at the peak of the crisis. Even most energy trusts–which were very hard hit by plunging oil and gas prices–maintained production strategies and slashed debt. Three avoided dividend cuts entirely: Crescent Point Energy (TSX: CPG, OTC: CSCTF), Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF).

How were these companies able to thrive as businesses while so many foundered and even perished? Chalk it up to the discipline of dividends.

Unlike the typical dividend-poor corporation, trusts’ generous payout policies mean they have to account for every dollar. And while some industries were ill-suited for that kind of regimen, those that have made it are now a unique breed of company capable of paying huge yields and growing at the same time.

That’s a concept many investors are still having trouble getting their hands around, having been brought up in an either income or growth mentality. That’s why we still see yields as high as 9.5 percent paid by companies like High Yield of the Month Just Energy Income Fund (TSX: JE-U, OTC: JUSTF), which grew its base of electric and gas customers by 28 percent last year.

But we are in fact witnessing the birth of a new breed of company–as trusts converting to corporations offer both robust growth and high income thanks to unmatched discipline. Although those extreme values are certain to disappear eventually as investors come to appreciate them, we now have a superb opportunity to buy them cheaply and ensure superb wealth-building for years to come.

The Conversion Myth

The table “Conversion Facts” has the basic details on the 31 former trusts in the Canadian Edge How They Rate universe to complete their conversions to corporations. “How Converters Have Fared” breaks it down company by company, along with any change in the dividend and when conversion was first announced.

The first takeaway from the data is almost every trust to convert rallied after announcing its intentions. That’s a reality 180 degrees different from the doomsday forecast by more than a few analysts on both sides of the border and feared by many investors.

The only trusts to register significant losses since announcing are in the energy services business, a sector currently in the depths of an intense cyclical decline.

The biggest loser, Aggressive Holding Trinidad Drilling (TSX: TDG, OTC: TDGCF), made its move in early January 2008. The shares rallied more than 50 percent from that point until mid-2008, when crashing energy price began to dry up drilling activity.

Here in mid-2010, Trindad and its peers like fellow loser-converter Precision Drilling (TSX: PD, NYSE: PDS) have seen some recovery in activity and equipment utilization by producers.

And they should see a whole lot more in the coming months, as producers shift their focus from the troubled offshore arena to onshore energy resources like shale oil and gas.

Profits and share prices, however, aren’t likely to fully recover until now-falling rig rental rates stabilize and head higher.

Underperformance by converting energy services trusts, however, is pretty much the exception that proves the rule. Their declines are due entirely to the ongoing slump in their sector, not the fact that they converted to corporations.

The second big takeaway is that while converters cutting dividends have outnumbered those not cutting to date, virtually all the later day conversions have either been cut-free or else have involved only modest cuts. Meanwhile, all of the conversions announced but still in progress have announced they’ll either cut marginally or not at all.

Last month, for example, new Conservative Holding Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXFF) announced it will maintain its current dividend rate after converting to a corporation on Jan. 1, 2011. That’s a pledge the company simultaneously backed up by announcing another quarter of robust earnings growth, with the promise of more for the rest of 2010.

Daylight Energy (TSX: DAY, OTC: DAYYF), meanwhile, did announce a cut from a monthly rate of CAD0.08 per month to CAD0.05 cents as it completed its conversion. But as I explain in Dividend Watch List, the reduction was well in line with expectations, given the continuing slump in natural gas prices and the company’s need for development cash. And it’s a far more benign outcome than the cuts made by gas producing converting trusts that converted earlier.

Of the 33 trusts with pending conversions that have announced future dividend policies, eight have announced they’ll cut dividends when they make their move. The average reduction is 29.5 percent, less than half the average reduction of companies already completing conversions.

Meanwhile, 23 have announced “cut-less” conversions to corporations. Two–Baytex Energy Trust (TSX: BTE, NYSE: BTE) and Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF)–have actually raised distributions since announcing their moves. That’s another stark contrast to dire assumptions many investors have made about what would happen to trust dividends in 2011.

Those fears, of course, still subsist to this day, despite the facts. Only a few dozen trusts have yet to announce post-conversion dividend policies, and even fewer are still undecided about converting. But the conventional wisdom still seems to be that some kind of day of reckoning is rapidly approaching.

Despite the positive gains we’ve seen in converting trusts, many investors I correspond with continue to ask if they’d just be better off waiting until 2011 to buy, when all have converted. Many seem to have trepidation even about companies that have already converted.

And small wonder: Many of the brokers investors count on to steer them through today’s fear-drenched market are actually warning them to avoid Canadian investments. Some are going so far as to tell clients that it’s illegal for US investors to own certain trusts, such as AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF), though the May High Yield of the Month routinely does five figures in daily volume through its five-letter over the counter (OTC) US symbol.

That’s not exactly what I’d call good service. But the continued pessimism in the face of bullish facts does explain a lot about why even trusts that have converted to corporations continue to trade at such low valuations. May’s other High Yield of the Month Colabor Group (TSX: GCL, OTC: COLFF), for example, has already converted to a corporation and continues to cover its distribution comfortably with cash flow as it grows its business. Yet it currently yields nearly 9 percent.

Skepticism runs perhaps even deeper for many of the trusts that have announced but not yet completed conversions. Enerplus Resources Fund (TX: ERF-U, NYSE: ERF) announced a cut-less conversion earlier this year but still trades at a sharp discount to the value of its assets in the ground and a yield of over 9 percent. Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) yields nearly 10 percent, despite hefty dividend coverage and already making its conversion dividend adjustment last year.

In the short term, investment markets are more often than not popularity contests. Finance Minister Jim Flaherty broke trust literally and figuratively when he announced 2011 taxation on Halloween night 2006. Since then, the Canadian government has made numerous investor friendly moves, including dramatic cuts in corporate tax rates, the elimination of the 15 percent withholding tax on dividends paid by Canadian common stocks held in US IRAs and easing rules to make trust conversions to corporations as painless as possible.

These moves have greatly improved prospective returns on Canadian investments, particularly converting trusts. For example, IRA investors stand to earn an effective 17.6 percent dividend increase for any trust they own that converts, as Canadian withholding goes away. But they’ve done little to mollify many income investors’ continued anger or to make converting trusts more popular in the marketplace.

Eventually, the stock market is very much a weighing machine. And sooner or later investors are going to find high yields paid by growing companies attractive, particularly if those dividends are paid in a hard currency like the Canadian dollar.

We may have to wait until 2011 before the taxation fears bedeviling trusts since Halloween 2006 finally go away. But when they do, today’s low valuations will be only a memory. That will mean strong gains in addition to high yields for those who buy in now. Latecomers, however, will have to settle for less.

Beating Expectations

Three months ago, I penned the Feature Article Trust Conversions: Flashing Bullish. I highlighted 20 trusts that were almost certain to convert to corporations but which had yet to announce a dividend policy. In an accompanying table, “Expectation Beaters,” I gave my forecast for what they would do with dividends as well as my read on what investors were expecting.

Since then we’ve heard from several, including AltaGas, Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), Cineplex Galaxy, Daylight Energy, Enbridge Income Fund (TSX: ENF-U, OTC: EBGUF), FutureMed Healthcare Income Fund (TSX: FMD-U, OTC: FMDHF) and North West Company Fund (TSX: NWF-U, OTC: NWTUF).

In some cases my forecast of the “likely outcome” for dividends was spot on. AltaGas wound up setting a post-conversion dividend lower than its trust payout but on the high side of a range management had set previously. Bell Aliant had given no real indication of what it would do before its announcement, though I surmised there would be some cut due to management’s desire to rapidly build out its fiber-to-the-home network in Atlantic Canada. The final cut was a bit higher than my projection but basically in line with it.

Bird and Cineplex Galaxy, as I expected, announced cut-less conversions, made possible by robust earnings. That was exactly what I thought the market was expecting for Bird, though better than projections for Cineplex. Most bullish was Enbridge Energy Income Fund’s announcement of a strategy whereby it would maintain its current dividend, resulting in a solid gain in its shares since despite the volatility of the Flash Crash.

On the other hand, my projections for no-cut conversions proved off for Daylight Energy, FutureMed and North West Company. That had nothing to do with earnings, which were again robust for the trio in the first quarter. Nor was it necessary to cover some financial weakness, as all three remain very solid.

Rather, management just proved to be more conservative than I expected when it came to setting the payout and elected to keep a greater portion of cash flow. In retrospect, that’s perfectly understandable, given the turmoil in the markets and worries about another credit contagion spreading from Europe.

Shepherding a greater amount of cash flow internally ensures management will be able to continue executing their growth strategies, even if credit markets should momentarily tighten. And if the macro environment does deteriorate, investors may yet come to be glad of the action, which won’t take place for FutureMed and North West Company until they complete their conversions probably later this year.

The bad news is unless you have a seat on the board, you’re just not going to be able to forecast distribution cuts based on management caution with any accuracy. The good news is you really don’t have to do that in order to make a profit from trust conversions. All that really has to happen is that the new payout beats what remain dreadfully low investor expectations. And as long as the trust’s underlying business is strong, that’s a cinch.

As it turned out, only FutureMed’s cut was in the range I considered to be “priced in,” as Daylight and North West Company were considerably larger. The cuts were, however, apparently very much in line with what consensus expectations really were. They may have disappointed me. But with their shares basically flat on the announcement, they still topped the abysmal projections of most.

Conversion Bets

If anything, baseline expectations have come down even more over the last month, for both converting trusts and Canadian equities in general. That should make realizing solid gains beating them even more like shooting fish in a barrel.

The only problem with betting on the rest of the trusts that haven’t announced conversions is we may have to wait right up to the end of the year to get the outcome. ARC Energy Trust (TSX: AET-U, OTC: AETUF), for example, announced it expects to pay a “similar” dividend as a corporation as it’s currently doing as a trust. But it’s also signaled that the exact future level will depend mainly on what happens to oil and gas prices, which are volatile as ever.

That’s clearly true of Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), which by management’s own admission is paying out more than it’s taking in with cash flow in order to maximize tax pools. In fact, barring a further rally in oil prices, it has signaled a reduction in distributions next year.

Penn West Energy Trust’s (TSX: PWT-U, NYSE: PWE) ground-breaking alliance with sovereign wealth fund China Investment Corp (CIC) provides needed funds to develop oil sands reserves management has not counted on in projections. CIC will be putting up substantially all of the development money in return for a half stake in the oil sands property as well as buying 5 percent of Penn West units.

The upshot is Penn West’s finances are stronger than ever, and its oil sands production will provide a valuable source of cash flow in coming years. That should make it easier to continue paying the current dividend, which was only 55 percent of first quarter cash flow. But again, management has hinted over and over again that it’s going to make at least some cut in its distribution.

As for Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), management stated at one time that it could maintain its current payout after a conversion. But as I point out in my analysis of its earnings in Portfolio Update, management may elect to invest in growth of reserves and output as a more “tax efficient” way to build wealth for investors, of which the company’s executives are major ones.

The truly positive thing about all four trusts, however, is they continue to trade well below the value of their reserves. That’s a clear sign that expectations are very low for their eventual corporate conversions.

No one should buy them or any other energy producing company unless they want to bet on a further recovery in energy prices, and by extension against a global economic relapse. But all have strongly rising production profiles, solid balance sheets and weathered the 2008 with their fortunes intact.

Buy up to prices in parentheses for substantial gains in the near term from beating conversion expectations, and for even bigger returns as their businesses continue to grow: ARC Energy Trust (USD22), Canadian Oil Sands Trust (USD30), Penn West Energy (USD22) and Peyto Energy Trust (USD15).

Canfor Pulp Income Fund (TSX: CFX, OTC: CFPUF) has increased its distribution by some 20-fold since November 2009 as its fortunes have dramatically improved. And even after the increases, the payout remains low at 63 percent. The time for monster capital gains is likely past for this cycle, as the units have soared more than 600 percent over the past 12 months. But with a current yield of more than 16 percent in a business that looks set to strengthen, there’s still upside for aggressive investors.

The great unknown is what management will do with its dividend when Canfor converts to a corporation, now planned for Jan. 1, 2011. In its first-quarter conference call, management stated it does “not expect a change in the distribution policy from the partnership” and “intends to distribute as quarterly dividends substantially all of the cash distributions received from the partnership.” That’s promising but it means surely that dividends are going to follow the volatile fortunes of the pulp industry. Again, the yield compensates for some of that risk. But Canfor Pulp Income Fund is a buy up to USD15 only for the aggressive, not for conservative income.

It’s a safe bet that Brookfield Real Estate Services Fund (TSX: BRE-U, OTC: BREUF) will pay as much of a dividend as parent Brookfield Asset Management (TSX: BAM/A, NYSE: BAM) believes it can. And solid coverage in the first quarter and a yield of nearly 11 percent mean odds are good that the trust will be expectations when it pays a dividend in 2011.

Still, investors should be careful not to pay more than USD12 for Brookfield Real Estate Services Trust, as rising interest rates do present at least some risk to the ongoing growth in the housing market on which the trust depends.

Parkland Income Fund (TSX; PKI-U, OTC: PKIUF) yields more than 12 percent despite management’s statement it intends to pay out between 75 and 110 percent of its current rate when it converts to a corporation. That’s a worst case of a 9 percent distribution in a fast growing energy refining, retailing and transport business that in many places is the only game in town and continues to grow rapidly.

The payout ratio of 87 percent in the first quarter is positive given the record warm winter, which reduced heating oil and propane profits by CAD2.8 million versus year ago levels. Weather evens out over time, even as asset growth builds the company’s earnings base. Buy Parkland Income Fund up to USD13.

Conservative Holdings CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) and IBI Income Fund (TSX: IBG-U, OTC: IBIBF) also appear set to be among the last trusts to set a defined dividend policy. That could prove to be a considerable positive for investors in both, given that profits have been tripped up of late by economic weakness in the US.

Bay Street at this point is somewhat more bullish on infrastructure design firm IBI than CML, which appears to have picked up some downgrades from buy to hold on fears of what’s going on in the US medical system. CML is off 30.1 percent this year in US dollar terms, with almost all of that coming after the passage of Washington’s health care legislation despite first-quarter earnings that seem to indicate the company’s US operations are improving. IBI, meanwhile, is down 17.6 percent, as one-time events in the US pushed the payout ratio up to 113 percent in the first quarter.

The good news is both stocks now yield well over 11 percent, levels that reflect widespread expectations for substantial dividend cuts at conversion or before. Not every company we buy works out. And despite some very strong growth trends at both CML and IBI, there’s always the change that economic and regulatory woes in the US could derail prospects. That’s why you never want to double down on a falling stock, no matter how good it may look.

On the other hand, my view is we definitely want to keep both of these companies, at least until we get another round of earnings. The expectations now built into their prices won’t be hard to beat if their underlying businesses are still solid, a question that should be a lot easier to answer with second quarter numbers. Until then, new investors can buy CML Healthcare Income Fund up to USD13 and IBI Income Fund up to USD17.

Finally, a comment on Conservative Holding Northern Property REIT (TSX: NPR-U, OTC: NPRUF): Management stated during its first-quarter conference call that it’s planning to convert from a real estate investment trust to a stapled share format in order to reduce prospective taxes from running afoul of the government’s new rules on qualified REITs.

Northern Property and other REITs had worked to tweak the law but apparently have concluded there’s little chance of working a change before taxes would kick in. That’s unfortunate, as the move won’t be cheap. It will, however, ensure Northern Property can continue to pay its dividend at the current generous rate.

As I detail in Portfolio Update, Northern’s core business remains solid and is cycling out of the downturn, despite some weakness in energy patch real estate. That remains the fundamental reason for owning the REIT, not its ability to avoid taxes. Until the company does make a move, however, its units are likely to stay a bit volatile, as they’ve been over the past month. My advice remains to buy Northern Property REIT on dips under USD22.