Many factors drive a stock’s price in the near term, even if it does pay generous dividends. Ultimately, however, high-yielding stocks follow one catalyst: dividend growth. If a company is raising its payout, its share price will follow.

Other factors, from economic ups and downs and interest rate swings to takeover rumors, can drive dividend-paying stocks higher or lower in the near term. Ultimately, however, they’re simply background noise.

Before Halloween 2006, Canadian income trusts’ unit prices followed the trend in their distributions religiously. In more stable businesses, such as pipelines and power generation, dividend boosts were usually predictable fare, occurring mostly once a year. Payouts of oil and gas producers, in contrast, followed the ebb and flow of energy prices. But regardless of sector, trusts’ prices generally rose when distributions were boosted and fell when they were cut as investors’ priced in a new rate of return.

All that changed with the ruling Conservative Party’s reversal of its pledge not to tax income trusts. More than a few of the strongest trusts have raised distributions at least once since Oct. 31, 2010. Increases at Artis REIT (TSX: AX-U, OTC: ARESF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF) were little surprise, as REITs were unaffected by the trust tax plan.

But many Canadian Edge Conservative Holdings that were affected also raised, including Atlantic Power Corp (TSX: ATP, NYSE: AT), Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF), Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF), CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF), Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF), IBI Income Fund (TSX: IBG-U, OTC: IBIBF), Just Energy Income Fund (TSX: JE-U, OTC: JUSTF), Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) and Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF).

In addition, Innergex Renewable Energy (TSX: INE, OTC: INGXF), Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) all raised distributions at least once after Halloween 2006 before adjusting them downward in the past year.

Despite exposure to the worst economic conditions in 80 years, Ag Growth International (TSX: AFN, OTC: AGGZF) managed a sizeable 21.4 percent distribution boost in mid-2008 and made it stick when converting to a corporation a year later. Finally, Vermilion Energy (TSX: VET, OTC: VETMF) held its 11.8 percent December 2007 dividend increase when it completed its conversion this week, despite unprecedented volatility in energy prices.

With the new trust tax front and center in the public psyche, however, the link between dividend growth and trust share gains was smashed. Rather, the key for the last four years has been how much of current distributions management would be willing and able to preserve after Jan. 1, 2011, when the new taxes kick in.

The flood of misinformation about the nature of the tax that poured out following the Halloween night 2006 announcement have further distorted market action. Understandably, during the massive two-week selloff of trusts that followed in November 2006, many investors didn’t wait around to find out the truth. To this day, however, there are massive misperceptions about exactly what taxes will be and where they will fall.

More than a few investors are still anticipating some kind of doomsday for trusts on Jan. 1, 2011, with wholesale liquidations, gutted dividends and plunging stock prices. Some fear losses that will dwarf those of the Halloween Massacre.

With that kind of misperception, it’s small wonder the distribution increases we’ve seen have fallen on deaf ears in the market place, particularly with investors so worried about the North American economy. Trusts’ unit prices have risen more than 60 percent from the Mar. 6, 2009, lows. And some, like Ag Growth, Atlantic, Brookfield, Cineplex, Colabor, Keyera and Pembina, have recently hit new all-time highs, besting both pre-2008 crash and pre-Halloween 2006 levels.

The broad-based S&P/Toronto Stock Exchange Income Trust Index is still nearly 30 percent below the range it held prior to Halloween 2006 and briefly revisited in mid-2008. Even former trusts that converted to corporations months ago still trade as though 2011 taxes are a risk.

That includes Colabor Group (TSX: GCL, OTC: COLFF). Despite the food distributor’s recession-resistant revenue stream and strong balance sheet, its shares still yield nearly 9 percent and are priced at just 1.6 times book value.

In the CE Portfolios, 15 trusts have declared their intention to convert to corporations, but are waiting until closer to January 2011 to make their move. Importantly, however, they’ve set post-conversion distribution rates in advance. As a result, they’ve also eliminated their 2011 tax risk.

Ironically, most are getting little or no credit in the market place for their candor. That investors are skeptical about Yellow Pages isn’t a surprise, given the heavy lifting management has had to do with advertising still soft and its market in transition from traditional print to Internet.

Doubts about companies like Just Energy, however, make a good deal less sense. The units still sell with a yield of nearly 9 percent, months after declaring a no-cut conversion. That’s despite management’s consistent affirmation of its intentions and demonstration of its ability to follow through with powerful operating numbers.

The upshot: Investors still fear a day of reckoning come January. Some still labor under the misperception there’s some kind of new tax coming directly on investors. To clarify, the only new taxes are falling at the corporate level, which means the sole impact on investors is what management does with its distributions.

In fact, investors holding trusts in IRAs and other tax deferred retirement accounts are on the verge of getting a substantial tax cut. The Canadian government is no longer withholding 15 percent of dividends paid by Canadian corporations into US tax-deferred accounts. As trusts convert to corporations, that 15 percent will start to flow into IRA accounts, amounting to an effective 17.6 percent dividend increase.

Note that this applies only to converted trusts, not those yet to convert. The Canadian government has drawn this distinction because unconverted trusts are still not paying corporate taxes. With this change, Canada becomes one of a very small handful of countries where US investors’ dividends aren’t withheld. For more on this issue, see Canadian Currents.

For other investors including many analysts, the day of reckoning lies in the economy. In fact, a near unanimous bearish consensus seems to have formed around the idea that a double-dip recession is about to take the stock market into a second down-leg of a “Big W” that began in mid-2008.

That’s reflected by the large number of analyst downgrades we’ve seen even of companies that reported robust second quarter numbers and guided toward even better in the second half of 2010. It’s apparent in the tenor of much of the reader feedback we receive at my publisher’s broad-based, lower-priced publications. And it’s clearly demonstrated by headlines popping up in the financial press, such as one this week titled “Face It, No One is Bullish Now.”

The obvious upshot is expectations remain very low for income trusts’ share prices and prospective distributions as we approach 2011, including those that have already made the jump to corporations. The good news is those expectations are going to very easy to beat, handing patient owners of high quality businesses a windfall in coming months.

More important, in its obsession with 2011, the market is completely ignoring what’s shaping up as an even more bullish portent and driver of investment returns: a return to robust dividend growth, and its ability to drive share prices higher.

Myth Busters

The greatest risk of 2011 taxation has always been what management would do to dividends once higher tax rates kicked in. As a major Canadian accounting firm stated in late 2006, there was a different potential tax strategy for every one of the 250-plus trusts that existed then.

A handful of trusts have elected not to convert in order to avoid restructuring costs. In fact, that appears to be an emerging model for trusts whose revenue comes from restaurant royalty pools. A&W Revenue Royalties Income Fund (TSX: AW-U, OTC: AWRRF) announced earlier this year that it would absorb taxes without changing structure or cutting its distribution. Last month Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF) followed suit by stating it would maintain its income trust status and remain a SIFT, or “specified investment flow-through” entity.

Boston Pizza’s rationale was that it would pay “approximately” the same taxes as a converted corporation as it would by remaining a SIFT, and that there was therefore no reason to “incur the significant administrative and legal costs associated with converting to a corporation.” Unlike A&W, Boston Pizza has made no assurances as to its dividend after it begins absorbing taxes. And with its bleeding of same store sales, I continue to rate Boston Pizza Royalties Income Fund a sell. A&W Revenue Royalties Income Fund is a buy up to USD18.

The vast majority of trusts, however, have elected to convert to ordinary corporations, thereby subjecting all taxable earnings to corporate tax rates. Managements have cited several factors making conversion advantageous, including the attraction of a simplified structure for investors. Increasingly, however, the biggest plus will be Canada’s falling corporate tax rates which, coupled with non-cash expense items and foreign income for some, means the effective tax rates on converted corporations are as low as 10 percent.

That’s a far cry from the official 28 percent imposed on SIFTs starting in 2011 and trumpeted as a harbinger of doom in the financial media. And the upshot is management has a lot more flexibility to pay generous distributions after absorbing taxes than was commonly believed.

In addition, management has had four years-plus to prepare for trust taxation. Aside from a handful of early converters, most have elected to maintain favorable tax status as long as possible, using the untaxed cash to cut debt and build earning power.

The cost to investors for the past four years has been generally slowed or halted dividend growth, made worse by the market/credit/economic crash of 2008. Damage was particularly acute in the energy business, where falling oil and gas prices triggered an unprecedented wave of dividend cuts in late 2008 and early 2009.

The benefit is the strong are now in better shape than ever to absorb the new taxes without abandoning their growth strategy or sacrificing their ability to pay dividends. That’s borne out by the expectation beating dividends being set by converting trusts.

Take a look at the table below, “How They Rate for 2011.” A brief scan of the 150 listings reveals several clear takeaways, all positive.

First, of all the companies listed, only 20 have yet to declare what their dividends will be when taxes kick in. Most of these have cash flows that depend heavily on commodity prices–meaning their distributions are always in flux–and management is waiting to get a better read on what those might be in early 2011 before acting.

We should have the final word for at least most of this group when third-quarter earnings are released beginning in late October. The full list is shown in Dividend Watch List. The five Canadian Edge Portfolio picks that have yet to announce are highlighted in Portfolio Update.

Second, 34 dividend-paying trusts have already converted to corporations, and another 30 haven’t yet converted but have set post-conversion dividends. The rest of the listings either won’t have to make adjustments in 2011, as they remain exempt, or else don’t pay dividends now. Forty-three companies that have either announced or completed conversions did not make dividend cuts, while most of the rest have been modest cuts generally equal to the expected bite of taxes.

Some of these companies could conceivably be hurt by business reversals between now and Dec. 31. But based on tax and conversion concerns alone, there’s absolutely no doubt what their dividends will be when 2011 rolls around. And that means there’s no 2011 uncertainty–and therefore risk to their share prices.

As I’ve pointed out above, today’s high yields and other low valuations for these companies indicate that even in the face of these facts investors are expecting precisely the opposite: that there is still dividend uncertainty due to 2011 risk.

Removing this misperception may require investors waking up in mid-January and discovering the sky hasn’t fallen. But sooner or later, reality is going to set in. The market will realize these yields are real and solid and valuations will adjust accordingly upward.

Even more exciting, however, are the implications from “Return to Growth.” Every month, I compile data on the selections of How They Rate for purposes of evaluating individual companies as well as market trends. One piece of data is monthly changes in distributions for listed companies.

“Return to Growth” basically compares the number of dividend increases with the number of dividend cuts for every calendar month, dating back to December 2007. The comparison is summarized by the “differential,” depicted in orange on the graphic.

The first takeaway is there were a substantial number of dividend cuts in early 2008 but also a large number of increases. The former were mostly due to trust conversions to corporations, most of which involved quite deep payout cuts.

The thinking at the time by management was that slashing dividends and preserving more operating cash flow was the best way to speed up earnings growth. The supposition was that damage from selling by income investors would quickly be recovered as growth investors and value seekers picked up the slack.

As it turned out, the strategy seemed to work at first for some. Trinidad Drilling (TSX: TDG, OTC: TDGCF) nearly doubled in the first half of 2008, as investors anxious to cash in on higher energy prices poured in. By the time the 2008 economic/market/credit crisis hit, however, the downside of dumping dividends was all too clear. Even dividend-cutters that have continued to post respectable growth like Aeroplan Group (TSX: AER, OTC: GAPFF) are still flat on their backs as stocks.

To make a long story short, they’ve fallen and they can’t get back up, regardless of their growth credentials. And their market fate stands in sharp contrast to the likes of Colabor–which converted without cutting–and others like Keyera, which has launched to all-time highs in large part by stating it will do the same.

The correspondingly large number of dividend increases in early 2008 was due to extraordinarily bullish conditions in the energy patch. As energy prices–particularly oil–soared to new heights so did energy producers’ cash flows. And despite pending 2011 taxation, they passed their good fortune along in a rising stream of distributions.

Those boom times, of course, ran out abruptly in the second half of 2008, as the market crash/recession/credit crunch sent oil prices plunging from over USD150 per barrel to less than USD30 and gas from the low teens to less than USD5 per million British thermal units. As a result, dividend cuts throughout the How They Rate universe exploded from October 2008 through March 2009.

On the plus side, the number of conversion-related cuts fell sharply by early 2009. Perceiving the value of dividends in a panicked market, most companies elected to maintain their tax benefits at least until markets stabilized. Those decisions were reinforced as the recovery unfolded in spring and summer 2009, as dividend-paying trusts far outperformed the dividend cutters in the share market.

Crescent Point Energy (TSX: CPG, OTC: CSCTF) was able to more than double its output in less than a year by financing a series of acquisitions with equity. The reason:  that equity surged in value thanks in large part to management’s decision to convert to a corporation in 2009 while leaving its monthly distribution rate of CAD0.23 intact. Rather than impeding growth, paying out generously actually provided the means through which Crescent Point could transform from a small player into a larger, more profitable, fast-growing one.

Not every company has been able to entirely follow the Crescent model, which was admittedly aided by its focus on oil production in a rising market. But even the most conservative managements–such as that at Davis + Henderson–are holding post-corporate conversion dividend reductions to levels that approximate their expected tax burdens. And like Davis + Henderson, converting trusts with strong underlying businesses are stating the new rates are merely a baseline for a return to growth as 2011 risks are put aside.

The data for the period from early 2009 reflects this new reality. As readers of my Dividend Watch List well know, dividend cuts are still happening, typically at the rate of two to three per month. But in 11 of the last 12 months, the number of dividend increases in the Canadian Edge universe has outnumbered decreases.

Moreover, for each of the last 13 months, at least three companies have hiked payouts. That’s a massive change from the late 2008, early 2009 period. More positive: The number of increases appears to be slowly but surely accelerating as we approach 2011.

Until companies have officially transitioned to corporations and have paid taxes for a while, management is likely to remain cautious. That conservatism is further reinforced by the memory of the 2008 debacle, which has kept investment conservative and focused management on controlling debt as much as funding growth.

That means even the strongest are likely to keep dividend growth modest until well into 2011. As companies’ strength continues to build, however, more entities will follow the example of Northern Property REIT, which hiked its payout 3.4 percent last month in response to very strong second-quarter earnings.

Everyone likes a rising stream of income, particularly when it’s paid in a currency that’s among the world’s best inflation hedges. In fact, Canadian dividend-paying equities are actually a far better inflation protection for income investors than gold, as a rise in the Canadian dollar’s value versus the US dollar effectively amounts to a dividend increase, while principal also rises.

The real benefit of a return to dividend growth, however, is a restoration of its historic link with Canadian share values. Removing the specter of 2011 is not only key to growing dividends, but also to resuming dividend growth’s historic role as a catalyst for rising share prices.

That’s a benefit few if any are looking for in this fear-drenched market, particularly for a group that’s been all over the map the last two years like Canadian high-yield equities. But as “Return to Growth” shows, it is the trend, and it promises to be an extremely profitable one for investors.

Where Growth Lies

What are the best candidates for growth? My forecast is sometime in the next 12 months, virtually every Canadian dividend-paying equity with a strong underlying business will increase its distribution.

Likely exceptions are companies like Innergex, which have stated plans for massive capital spending and are taking advantage of a 40-year low in capital costs as well as post-recession lows in material and labor costs. Companies whose fortunes are closely tied to the economy’s health are also likely to go slow, including Yellow Pages.

Their urgent task, rather, is to prove they can sustain current dividend rates in the face of extreme investor skepticism. If they can do that, we’ll have rewards enough as shares recover ground lost the past few years, in Yellow’s case quite possibly soon after it converts to a corporation on Nov. 1.

Oil and gas producers’ distributions depend as much on energy prices as the efficiency and output from their operations. That was true when they were trusts, and it will be as they convert to corporations.

In the case of oil-focused producers like Bonterra Energy Corp (TSX: BNE, OTC: BNEFF)–which converted to a corporation two years ago–that remains a huge benefit. In fact, the company has boosted its distribution four times since converting, most recently in July. Its monthly payout is now 22.2 percent more than when it converted to a trust in 2001.

For natural gas-focused producers, however, low selling prices mean challenges just maintaining current payout rates, particularly for those yet to announce post-conversion distributions. That even includes Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), which has operating costs that are one-fifth those of the rest of the industry.

Peyto’s reserve life of more than 20 years based on proven reserves is more than twice the industry average, and its gas has higher heat content than that of rivals, meaning it can charge a premium price. Nonetheless, management is still not committing to a post-conversion payout level and the potential for a cut is definitely priced in with the yield nearly 10 percent.

Oil-focused producers are definite candidates for dividend increases in the coming months. Not only is the price of their product supported by vibrant and accelerating global demand. But they’ve been using cash flow to boost launch an unprecedented wave of capital spending on growth. Bonterra Energy Corp is a buy up to USD35.

I also remain a big fan of Vermilion Energy, which has completed its conversion to a corporation as expected without cutting its distribution. As pointed out in Portfolio Update, the company is squarely positioned for robust growth in output globally.

Because it sells oil and gas in Europe, Asia and North America, it enjoys far more stability in realized selling prices than other dividend-paying producers. And debt is virtually non-existent at 0.5 times annualized cash flow. Coupled with a very low payout ratio even including planned capital spending, that adds up to potential for another dividend increase over the next year, particularly if oil prices rise another USD10 per barrel from here. Buy Vermilion Energy up to my raised target of USD35.

Real estate investment trusts (REIT) are also strong candidates for dividend growth. Many of these, including Northern Property, had to make some adjustments to comply with the government’s new rules on REIT status. But slowly but surely Artis, Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Northern, RioCan and others have been able to put the cash raised over the past year into very high-quality properties financed at generation-low interest rates.

That’s a formula that’s already translating into strong cash flow growth and increasingly distribution growth. All of the REITs highlighted in the August Feature Article remain strong buys up to my target prices, particularly the Conservative Holdings’ Fantastic Four: Artis REIT (buy up to USD12), Canadian Apartment Properties REIT (USD16), Northern Property REIT (USD22) and RioCan REIT (USD20).

Other good candidates for payout increases are companies that are planning cuts in dividends to very conservative levels when they convert, despite continuing to post robust results. Management at AltaGas Ltd (TSX: ALA, OTC: ATGFF), Davis + Henderson and others took a lot of heat for announcing larger than expected payout cuts in advance of conversion. AltaGas has now converted and is paying at its new monthly rate of CAD0.11, while Davis plans its reduction to a rate of CAD0.10 per month when it converts on Jan. 1, 2011.

Both have since posted very strong results, AltaGas by adding more gas and power assets and Davis + Henderson by integrating recent acquisitions. As a result, payout ratios are going to be very conservative for both companies in 2011, even if the Canadian economy stays sluggish. Management may use some of that cash to grow further. But with minimal debt maturities the next few years, it’s likely to return some of the surplus to shareholders.