Canadian trusts, including those that have converted, those that will do so by Jan. 1, 2011 and one, Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CHEFF), that will keep its current structure, have proven the fear of a post-2010 world entirely unjustified. US-based investors who stuck with the group have been rewarded with solid, dividend-driven outperformance despite disastrous interference by government and unprecedented threats to the global economy.

Political uncertainty undermined Canadian trusts in the marketplace starting in 2005. Liberal Finance Minister Ralph Goodale first ended his department’s practice of fast-tracking corporation-to-income trust conversions via “advance tax rulings.” This move to slow these conversions also fueled rumors that the government would push for some form of entity-level tax on trusts. Mr. Goodale provided what proved to be a temporary reprieve over Thanksgiving weekend 2005, as he committed the sitting government to the status quo.

As has been well documented, a Conservative upstart led his party to a February 2006 electoral win, though Stephen Harper assumed leadership of a minority government. Nevertheless, and contrary to a campaign promise, on Oct. 31, 2006, new Finance Minister Jim Flaherty announced what he called the “Tax Fairness Plan,” a scheme designed by current Bank of Canada Governor Mark Carney, who was then a Senior Associate Deputy Minister of Finance. The plan gave Canadian trusts until Jan. 1, 2011, to convert or begin paying corporate-style taxes.

Short-termers and the panicked predicted doom, and they were right. By mid-November 2006 the S&P/Toronto Stock Exchange Income Trust Index had shed more than 20 percent, and an estimated USD30 billion of investor wealth had been wiped out. This selloff was nothing compared to what was on the horizon, however, and the SPRTCM even got within a decent day’s rally of its all-time high in mid-2008. Resilient in the aftermath of the Goodale threat, Canadian trusts had even overcome Flaherty’s “death knell.”

A little less than a year later early signs of cracks in the global financial system began to appear, first in the UK with Northern Rock, a bank with a lot of exposure to subprime mortgages. Northern Rock, nationalized in early 2008, was a sign of things to come. The fall of Lehman Brothers later that year triggered a lending that turned an ordinary downturn into the Great Recession. (On Dec. 1, 2008, the National Bureau of Economic Research announced that the US entered recession in December 2007.)

By March 2009 the SPRTCM was below 76, down from an April 2006 record above 176. But the index only captures unit-price movements. Although over the long run the price of dividend-paying stocks follows the monthly, quarterly or semi-annual payout, the market was tossing Canadian trusts out with everything else, despite the fact that–at least in the Canadian Edge Portfolio–there was no rash of extreme dividend cuts. Maintaining market-beating distributions helped Canadian trust investors hang on while other investors got wiped out. 

True to form, the SPRTCM rebounded faster than both the S&P/Toronto Stock Exchange Composite Index (SPTSX) and the S&P 500, bettering its Canadian counterpart by 33 percent and nearly doubling the US benchmark on a total return basis since the first week of March 2009. Big dividends have certainly helped, but on a price-only basis in US dollar terms the SPRTCM is up 112 percent, the SPTSX 97 percent, the S&P 500 65 percent from the recent bottom through Aug. 4, 2010.

The market has demonstrated time and again that it wants what Canadian trusts and their successors as high dividend-payers offer: solid income streams that flow no matter the economic terrain. And, similarly, the people responsible for managing these businesses understand that they need to distinguish themselves to compete for capital. Canadian trusts have endured a volatile 45 months since Halloween 2006. The government’s blow to trusts’ very existence was followed in close combination by the onset of the worst recession in more than six decades.

Stress-tested Canadian trusts and high-yielding corporations backed by solid underlying businesses will withstand the calendar’s turn to 2011.

Canadian Trusts: Conversions Are Bullish

Since its inception on Oct. 15, 2002, the SPRTCM has soundly outperformed both the broader SPTSX and the S&P 500 on a total return basis. The various stress tests they’ve endured validate Canadian trusts’ essential proposition, that solid operating companies can share outsized portions of cash flow with investors on a regular basis. Underlying business strength–not legal structure–is the most important factor to weigh for income investors. Whether trust or corporation, we want to know that cash flow is covering and will continue to cover the dividend.

As was written in CE in the aftermath of Halloween 2006, there are as many solutions to the problem of taxation as there are Canadian trusts. In other words, each company had to evaluate its operations and cash flow and how it would sustain and grow in light of entity-level taxation. That presents different problems to, for example, movie theater operator Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF) than it is does to oil and producer Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF).

Nevertheless, both companies will maintain their current payout rates beyond Jan. 1, 2011. Cineplex Galaxy enjoys a dominant position in the Canadian market, with more than 1,000 screens; the No. 2 operator has less than 500. It’s also the fifth-largest chain in North America. Enerplus, for its part, has always maintained a conservative payout ratio; a solid production mix, tilted toward gas but including significant oil output, as well as its geographic profile mean Enerplus will be able to keep its dividend at trust levels once it converts.  

CE Conservative Holding Cineplex Galaxy yields more than 6 percent at current levels, while Aggressive Holding Enerplus pays out 9 percent. These businesses held up well during the recession. Hollywood seems to have found a consistent formula and consumers still had enough disposable income to attend relatively inexpensive movies, while rising demand from emerging markets offset to some degree declining demand from developed economies, keeping oil prices elevated in an historical context; natural gas has simply been consistently depressed.

Other Portfolio Holdings took more aggressive steps to prepare for 2011, in light of new taxation as well as deteriorating economic conditions. Conservative Holding Just Energy Income Fund (TSX: JE-U, OTC: JUSTF) slashed its distribution one time, in mid-2008. The energy distributor has positioned itself, with acquisitions and debt repayment, to not only sustain but grow its corporate dividend in coming years.

Former Aggressive Holding Advantage Oil & Gas (TSX: AAV, NYSE: AAV), meanwhile, turned the existential threat posed by the trust tax into an opportunity to convert into a growth-oriented natural gas producer. Advantage decided to shepherd all the cash it could to exploit its considerable assets in the prolific Montney Shale play in northwestern Alberta. The company’s derring-do has been rewarded, as have shareholders, with impressive production growth and a rally from below USD2 in early March 2009 to above USD6.30 today.

Fewer than 30 members of the Canadian Edge How They Rate coverage universe have yet to make their post-2010 intentions clear. The last time we took an in-depth look at the facts of Canadian trusts’ conversions, in the June 2010 CE feature story, those that had completed the process generated an aggregate post-conversion average return of more than 40 percent. Much of the bounce is explained by the elimination of some uncertainty, that surrounding post-2010 dividend plans.

The market loathes the unknown; clearing up payout intentions settles the most important variable for income-focused investors. It’s such a critical factor these days that we give trusts one point in the Canadian Edge Safety Rating System for clearly stating dividend terms for post-conversion shareholders.

Many trusts that have converted reduced their trust-level payout to reflect the additional demand on cash flow inflicted by the Tax Fairness Act. Not all businesses are suited to carry on this way; we studiously avoided even taking up coverage of converting companies that seemed to be doing so for questionable reasons such as affecting a convenient cash-out for insiders. Many, however, can survive and thrive within the tight parameters defined by the high-dividend model.

The Halloween 2006 trust tax announcement enforced a discipline on a sector that had grown wildly during the early 2000s boom, from which only the heartiest would emerge. The private capital takeover binge of early 2007 enabled some four dozen trusts in the CE universe to take the easy way out via profitable buyouts. Mergers between trusts also surged, as smaller companies became stronger with scale.

Trusts that endured the political saga over trust taxation, the financial crisis and the economic meltdown provide compelling proof of their long-term viability and wealth-building potential. The 2008-09 market 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. What distinguishes our Canadian Edge Portfolio Holdings is that their capital requirements are generally relatively predictable, the market’s need for what they do is easily understood, and their positions within their respective markets are well defined.

The flight of the SPRTCM since October 2002 follows closely up-trends for gold, crude oil and the Canadian dollar versus the US dollar. The crisis of 2007-09 interrupted a long-term bull market for hard assets, currencies linked to them, and our friend the Great White North. And Canadian trusts and their high-yielding offspring offer exposure to the best economic story in the developed world.

The Roundup

We’re in the thick of second-quarter reporting season for Canadian Edge Portfolio Holdings and the How They Rate coverage universe.

We’ll have the details on Conservative Holdings AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF), Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), RioCan REIT (TSX: REI-U, OTC: RIOCF) and TransForce (TSX: TFI, OTC: TFIFF) and Aggressive Holding Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) in the August Portfolio Update, which will be available tomorrow along with the rest of the regular issue of Canadian Edge.  

We’ll also have earnings highlights from How They Rate in the August Canadian Currents.

Here are second-quarter earnings announcement dates for Conservative Portfolio recommendations:

• Artis REIT (TSX: AX-U, OTC: ARESF)–August 11 (confirmed)
• Atlantic Power Corp (TSX: ATP, OTC: ATLIF)–August 9 (confirmed)
• Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF)–August 11
• Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF)–August 9 (confirmed)
• Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–August 10 (confirmed)
• Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF)–August 12 (confirmed)
• CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF)–August 12
• Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF)–August 10 (confirmed)
• IBI Income Fund (TSX: IBG-U, OTC: IBIBF)–August 5
• Innergex Renewable Energy (TSX: INE, OTC: INGXF)–August 13
• Just Energy Income Fund (TSX: JE-U, OTC: JUSTF)–August 6
• Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF)–August 4 (confirmed)
• Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF)–August 9 (confirmed)
• Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–August 4 (confirmed)
• Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF)–August 5 (confirmed)
• Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF)–August 6

Aggressive Holdings

Here are second-quarter earnings announcement dates for Aggressive Portfolio recommendations:

• Ag Growth International (TSX: AFN, OTC: AGGZF)–August 11 (confirmed)
• ARC Energy Trust (TSX: AET-U, OTC: AETUF)–August 4 (confirmed)
• Daylight Energy (TSX: DAY, OTC: DAYYF)–August 5
• Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF)–August 6 (confirmed)
• Newalta Income Fund (TSX: NAL, OTC: NWLTF)–August 6
• Perpetual Energy (TSX: PMT, OTC: PMGYF)–August 6
• Penn West Energy Trust (TSX: PWT-U, NYSE: PWE)–August 5 (confirmed)
• Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF)–August 12
• Provident Energy Trust (TSX: PVE-U, NYSE: PVX)–August 13
• Trinidad Drilling (TSX: TDG, OTC: TDGCF)–August 11 (confirmed)
• Vermilion Energy Trust (TSX: VET-U, OTC: VETMF)–August 6