By any measure, 2009 and 2010 were the stuff of investors’ wildest fantasies–at least for Canadian Edge Portfolio stocks.

Even back in the dark days of early 2009, I never lost confidence in my holdings’ ability to bounce back, as long as their underlying businesses stayed healthy. But not even I envisioned our stocks would score an average total return of 65.5 percent in 2009, followed by another 40 percent-plus in 2010.

Gains like these beg the question of whether we can possibly hope for what amounts to a hat trick in hockey, Canada’s national pastime–i.e., a third consecutive year of robust total returns for Canadian stocks.

Not surprisingly, such ultra-bullish market events have been decidedly rare throughout history. In fact, massive returns like these have usually sown the seeds for sometimes equally gut-wrenching declines.

The main reason is that rising share prices are always accompanied by higher expectations. It’s one thing to buy a high-quality company like Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF) on day like Mar. 13, 2009, when no one wants it and it trades at less than USD12 per share and yields 13 percent.

It’s another entirely to pony up to buy it 21 months later when it’s popular at price of nearly USD22 and yields only a little over 7 percent.

You’re still getting the same high-quality company. In fact, the owner and operator of midstream energy infrastructure is arguably much more valuable as a business today, after adding a host of new assets focused on the growth of Canada’s oil sands and the rising popularity of natural gas liquids.

The difference is a 13 percent yield signals investor expectations are rock bottom. In fact, back in fear-choked early 2009, all Pembina Pipeline arguably had to do to ensure a huge return for shareholders was maintain its dividend. And the same was true for dozens of other high-yielding Canadian trusts and corporations.

Even companies that cut distributions as part of converting to corporations have realized huge returns since. Now converted Davis + Henderson Corp (TSX: DH, OTC: DHIFF), for example, announced in March 2010 that it would cut its dividend 34.8 percent when it converted in January 2011.

Yet the stock has returned more than 200 percent since its early 2009 low.

Yields of 6 and 7 percent such as Davis + Henderson and Pembina Pipeline now offer, respectively, are still generous, particularly compared to anything else on the market. Both companies are in the pink of health, with dividend growth likely in coming years.

But those higher prices and lower yields clearly indicate higher expectations from investors. And should either stumble during upcoming earnings season, share prices will take a hit.

Happily, higher expectations notwithstanding, I believe high-yielding Canadian stocks–particularly former trusts like Davis + Henderson and Pembina Pipeline–do have the opportunity to pull off a hat trick in 2011. For one thing, a sizeable chunk of those gains we’ve seen since March 2009 are simply a comeback from the historic market crash/recession/credit crunch of late 2008, which pushed them to deeply undervalued levels.

Much of the rest is arguably due to a similar recovery from the panic selling that followed Canadian Finance Minister Jim Flaherty’s announcement of the trust tax on Halloween night 2006. Trusts did have four years-plus to adapt to the tax; the best have done so extremely effectively.

The flipside, however, is their share prices have languished all that time, due to overblown fears about what 2011 taxation would bring. And it’s only now that the conversion process is complete and dividends are set that the fearful are coming back to the party and wiping out that undervaluation.

In the September 2010 Feature Article, Return to Growth, I forecast a return to dividend growth for the former trusts once the conversion process was done and they got used to paying taxes. I’m even more convinced of that now after generally robust third-quarter 2010 earnings and what’s mostly been a smooth conversion process.

Before the 2011 tax became an issue, share prices of high-yielding Canadian stocks and trusts always followed their level of dividends. Many factors triggered ups and downs in the short run.

But over time share prices always reverted back to the mean of where the dividends were. Dividend growth invariably pushed share prices higher.

That favorable dynamic will return over the next several years. In fact, as this month’s Feature Article demonstrates, we’re increasingly likely to see the strongest move that way this year, as the long-slumping US economy repairs itself.

Natural resource companies look set to continue benefitting from tight global supply-demand conditions, which will only get tighter as US demand heats up.

And economic healing itself is a reason to expect another year of at least solid returns for high-yielding Canadian stocks. That’s partly because for the past three years they’ve decoupled from interest rates and instead have followed the prospects for growth, rising on improving growth and slipping on slumps.

Even inflation doesn’t look like much of a threat now, despite the incessant handwringing in the media. The type of wage-push inflation we saw in the 1970s is simply impossible with so many unemployed and so much productive capacity idled in North America.

If there is inflation, it will be commodity-push in nature, which will benefit Canadian exports and hence the Canadian dollar. That’s in fact a built-in hedge for US investors, as any drop in the US dollar will boost the value of our Canadian investments as well as the value of the dividends paid.

Should all of these stars align favorably, there’s no question our Canadian favorites will have another good year, be it 20, 30 or even 40 percent returns. And keep in mind that even a dividend yield of 6 percent puts you well ahead of the game starting out.

Rather, the primary risk for investors is that the stocks they own won’t live up to today’s higher expectations as they post earnings numbers in coming months. No matter how bullish the macro environment, they’ll produce only mediocre returns, at best.

The question of whether we get the hat trick or not is going to depend on how our individual companies perform as businesses. That means redoubling our efforts to assure we have the highest-quality names, not just a collection of stocks with good-looking yields and little behind it.

A New Rating System

The Canadian Edge Safety Rating System is the key to assuring we’re focused on quality. Its purpose is to separate the strong and growing businesses from the rest. After the conversion wave of early January, most of the How They Rate universe is organized as corporations. That doesn’t change my strategy or even my way of looking at them. But it does mandate some changes in the criteria I use, in fact a revised Safety Rating System.

As before, I’m still rating companies on a scale of 0 (riskiest) to 6 (safest) based on six criteria intended to gauge sustainability of distributions. The Safety Rating is how many criteria are met.

The final number is a relative gauge of safety for every investment analyzed in Canadian Edge. Companies with CE Safety Ratings of 5 and 6 are safe enough for income investors of all stripes. But even companies with ratings of 0 can be buys on the basis of being able to generate superior returns, for those who can handle the obviously greater risk.

Conversely, not every company rated 5 or 6 is necessarily a buy. In some cases, buy-in prices are just simply too high. Even a great company can fall short of expectations and therefore lose money for investors.

Running down the criteria, the payout ratio remains the cornerstone of the System. It’s basically the dividend as a percentage of profits available to pay dividends. Every quarter, I report these numbers in How They Rate by dividing the dividend rate by profits. Results for the third quarter of 2010–the most recently available–are currently shown.

Unfortunately, while the concept is simple the application of the payout ratio is decidedly not. The main reason is the proper measure of profits varies from company to company. Many peg their dividend policies to post-tax earnings per share (EPS). However others, particularly most former income trusts, pay according to the level of distributable cash flow (DCF).

For these companies–which include REITs and the remaining income trusts–EPS is basically worthless as a measurement of profits. In fact, using EPS as a gauge can be incredibly misleading, providing either a false sense of security or an exaggerated picture of risk.

The Canadian government has imposed new taxes. But it didn’t kill the desire of companies to pay out big dividends. Nor do the new levies prevent companies from sheltering income from taxes, and thereby increasing DCF and minimizing EPS.

At this point, DCF per share isn’t a standard measure under Generally Acceptable Accounting Principles. But it is widely enough used now so that it does tend to be consistent across the companies that use it.

Basically, DCF is revenue less all cash expenses, including what’s needed to maintain assets, commonly known as maintenance capital spending. It’s basically what companies have left over each quarter to pay dividends, grow the business and pay off debt.

The second thing to keep in mind with payout ratios is they can be quite seasonal in some businesses. The spring quarter, for example, is always light for companies that produce oil and gas or provide energy services, as the thaw depresses activity. Power trusts reliant on hydro flows are often negatively affected in drier periods of the year. Apartment REITs typically have a tight winter quarter because most cover heating bills for tenants.

This was of course true in the trust era and it remains true after the conversion wave. As long as we have the proper metric to measure profits, however, there’s no better gauge for dividend safety.

Two of the six points in the Safety Rating System are determined by payout ratio. If a company’s payout ratio comes in below a certain level required for its sector, it gets a point. But if it’s superior for its class, the company will score two points.

Under the old system I measured debt solely by the debt-to-assets ratio, which is also shown for each company in How They Rate. Companies get a point for having a debt-to-assets ratio below a certain percentage designated for their group.

The new Safety Rating System adds a second criterion for debt: total obligations coming due the next two years (prior to Jan. 1, 2013) as a percentage of total market capitalization (outstanding shares times share price).

The result is a gauge of refinancing risk for each company reviewed. I’ve presented this data before for CE Portfolio holdings in prior updates. This month is the first I’ve included it in the ratings system, as well as applied it to the entire How They Rate universe.

To review, the lower the percentage the less a company has to refinance over the next couple years, and therefore the lower its refinancing risk. A company with a “zero,” for example, has no near-term refinancing needs and is entirely immune should credit markets freeze up again as in late 2008.

My view remains a reprise of 2008 is unlikely precisely because so few companies in our universe have significant refinancing needs for at least the next two years. Companies that do have refinancing needs will likely be able to boost their earnings by refinancing what debt they have at today’s historically low cost of capital.

There’s always the chance, however, that a particular company will be forced to turn to credit markets when conditions have toughened up. Even if things do improve shortly thereafter, they’ll still face higher borrowing costs that will eat into profits, with perhaps fatal consequences for dividends. Consequently, companies with percentages under 10 get a point for meeting this criterion. The rest do not.

Criterion No. 5 is the nature of the business of each company. As we saw in the 2008-09 meltdown certain businesses are extremely resistant to economic shocks. Their cash flows hold up, so their dividends do also, ensuring recovery in the share market from selloffs. These include pipelines, electric power companies and anything else involved with infrastructure.

In contrast are resource producer companies, which showed once again in 2008-09 that economic collapse and lower commodity prices inevitably cut into cash flows and almost always hit dividends. Accordingly, companies in economically resistant businesses receive a Safety Rating point on this score, while resource companies do not.

I had this criterion as part of the former rating system. The difference now is that, with the benefit of 2008, I’ve been able to discern better what businesses are indeed cyclical, and which we can hold with utmost confidence during the next downturn.

Again, I’m not one who expects an economic relapse in 2011. In fact, if anything we should see faster-than-expected growth. Should a dip occur, however, a non-cyclical company has a far better chance of generating a strong return than a cyclical one. And sorting that out is what a ratings system is for.

Under the old system, I gave companies a point whenever they clarified what their post-conversion dividends would be. My logic was that once an announcement was made, the uncertainty and therefore the primary risk was no more, even if a dividend cut was involved.

That theory has held up well since, evidenced by the subsequent gains posted by almost every company clarifying its post-conversion payout policy. The very act of removing uncertainty was enough to dispel worry and bring back the buyers.

With virtually all conversions behind us, however, this is no longer a valid criterion for a ratings system. Every company in How They Rate earns it. It’s no longer a point of distinction and in fact it’s irrelevant to assessing the risks to come.

Consequently, I’m replacing it as of now with a more relevant and infinitely more defining criterion: no dividend cuts over the past five years.

As anyone who’s held Canadian Edge recommendations since January 2006 knows, the past five years have been a period of extraordinary volatility. First was the crash in natural gas prices that followed the spike up in the wake of hurricanes Katrina and Rita in late 2005. That caught a large number of gas-focused producers in an aggressive, over-leveraged position.

That year also saw an unprecedented boom of new income trust initial public offerings, following the Conservative Party victory in Canadian parliamentary elections. The result was much more competition for trusts to raise capital, which to then had been the primary way they financed growth.

The aftermath of the Oct. 31, 2006, trust tax announcement, of course, lowered the boom on new issues and dried up capital even for the strongest as well. Some companies took advantage of the private capital boom to be bought out in the first half 2007 merger wave. By later in the year takeover activity stalled, too, as capital become noticeably more difficult to come by.

The spike in energy prices in 2008 induced many producers to jack up dividends, a policy they eventually had to reverse with devastating consequences when oil plunged back below USD30 a barrel. That, of course, occurred at the same time as an 80-year-worst credit crunch jacked up the cost of debt, forcing companies to further retrench and live within their own often shrinking means.

In the year that followed (2009), the recession bit into revenue at any company involved in natural resource development, as well as those with extensive operations in the even worse off US. And finally, the approach of 2011 taxation and the end of hope of a reprieve forced companies to consider what they could pay out under their approaching burdens.

In short, it’s been one stress test after another for the companies in the Canadian Edge coverage universe over the past five years. Any company–trust or corporation–that’s been able to avoid a dividend cut through that is a true gem, and not because of the nature of its business. Rather, all the credit goes to management’s skill in keeping the ship pointed in the right direction.

Some sectors, of course, were healthier than others, such as midstream energy infrastructure. Even here, however, some stumbled by over-leveraging or focusing on projects that soured. Conversely, even the most economically sensitive sectors, like resource production, featured companies like Vermilion Energy Inc (TSX: VET, OTC: VEMTF) that somehow maintained and even increased their distributions, despite the turmoil engulfing the rest of their industries.

Meeting the criteria of no dividend cuts in five years is in a sense the ultimate A+ report card for management. It’s no guarantee something won’t happen to force a dividend cut during the next five years. But coupled with the rest of the criteria, it gives a complete picture of the health of each company now. And that’s the best we can do for assessing business quality, at least until we get our next set of numbers.

The table “A New Ratings System” shows how each of the Portfolio recommendations measures up on each of these criteria. The most important takeaway is that virtually all of the companies stack up well, particularly those in the Conservative Holdings.

That’s what I expected to see. But it’s nonetheless gratifying to see and it eliminates at least for now what could have been a very real reason for some extraction.

Interestingly, both the companies I recommended selling in the Dec. 20 Flash Alert—Bell Aliant Inc (TSX: BA, OTC: BLIAF) and Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF)–fared worse under the rating system change. Bell Aliant still draws a decent rating of 4, stacking up generally well on its numbers as well as the stability of its rural phone business. Canfor Pulp, however, now rates only a 1.

Of course, both companies have the added drawback of uncertain behavior toward US investors. As I pointed out in the Flash Alert and again for Canfor Pulp in Dividend Watch List, there’s really no way to tell whether or not US investors’ shares have been pooled and sold already, or whether or not the shares now traded under the five-letter US over-the-counter (OTC) symbol CFPUF are actually restricted shares. Ditto what’s traded for Bell Aliant under BLIAF.

Even if both of these companies were in the pink of health and had gained ground under my ratings system, I wouldn’t touch them with a 10-foot pole right now. Now with the lower ratings indicating worse business fundamentals, they may not be worth going near even when these questions are settled, even if OTC trading should be non-restricted.

If you still own Bell Aliant Inc and Canfor Pulp Products Inc, my best advice now is to try to sell them. Bell Aliant has generally held its value since conversion. If you can sell, you’ll get about as good a price as have been available for some months. Canfor Pulp has continued to lose ground but is still within a couple points at least of our initial entry point in October 2010.

Meanwhile, High Yield of the Month Extendicare REIT (TSX: EXE-U, OTC: EXETF) is a solid replacement for Bell Aliant. Not only are its shares not restricted for US investors, but its yield of over 9 percent is two percentage points higher than Bell’s post-conversion yield of about 7 percent. Buy Extendicare REIT up to USD10.

As was the case with the old rating system, when numbers change, so do ratings. The next big potential shift will be from early February through early March, when fourth-quarter and full-year 2010 earnings are announced. Below I’ve listed estimated dates (except where noted) for earnings announcements by recommended companies. Note that Consumers’ Waterheater Income Fund is now EnerCare Inc (TSX: ECI, OTC: CSUWF).

Conservative Holdings

• AltaGas Ltd (TSX: ALA, OTC: ATGFF)–Feb. 23
• Artis REIT (TSX: AX-U, OTC: ARESF)–Mar. 16
• Atlantic Power Corp (TSX: ATP, NYSE: AT)–Mar. 29
• Bird Construction Inc (TSX: BDT, OTC: TBD)–Mar. 11
• Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF)–Feb. 9
• Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–Feb. 24
• Cineplex Inc (TSX: CGX, OTC: CPXGF)–Feb. 11
• CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Mar. 4
• Colabor Group Inc (TSX: GCL, OTC: COLFF)–Feb. 24
• Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)–Mar. 2
• Extendicare REIT (TSX: EXE-U, OTC: EXETF)–March 16
• IBI Group Inc (TSX: IBG, OTC: IBIBF)–Mar. 17
• Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)–Mar. 22
• Just Energy Group Inc (TSX: JE, OTC: JSTEF)–Feb. 11
• Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF)–Feb. 18
• Macquarie Power & Infrastructure Corp (OTC: MPT, OTC: MCQPF)–Mar. 2
• Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Mar. 17
• Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–Mar. 3
• RioCan REIT (TSX: REI-U, OTC: RIOCF)–Feb. 9
• TransForce Inc (TSX: TFI, OTC: TFIFF)–Mar. 2 (confirmed)

Aggressive Holdings

• Ag Growth International Inc (TSX: AFN, OTC: AGGZF)–Mar. 11
• ARC Resources Ltd (TSX: ARX, OTC: AETUF)–Feb. 9
• Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)–Feb. 24
• Daylight Energy Ltd (TSX: DAY, OTC: DAYYF)–Mar. 2
• EnerCare Inc (TSX: ECI, OTC: CSUWF)–Mar. 1
• Enerplus Corp (TSX: ERF, NYSE: ERF)–Feb. 25
• Newalta Corp (TSX: NAL, OTC: NWLTF)–Mar. 2
• Parkland Fuel Corp (TSX: PKI, OTC: PKIUF)–Mar. 2
• Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE)–Feb. 18
• Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–Mar. 9
• Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF)–Mar. 10
• PHX Energy Services Corp (TSX: PHX, OTC: PHXHF)–Mar. 3
• Provident Energy Ltd (TSX: PVE, NYSE: PVX)–Mar. 11
• Vermilion Energy Inc (TSX: VET, OTC: VEMTF)–Mar. 3
• Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Feb. 11

In addition to Safety Rating changes, numbers have the potential to raise or lower buy targets. As a brief glance at the Portfolio tables reveals, many of my recommendations now trade above my buy targets, some, like Vermilion, well above.

My strong advice is not to chase them. There are some recommendations that continue to trade well below targets, including new addition Extendicare and fellow High Yield of the Month Macquarie Power & Infrastructure Corp (TSX: MPT, OTC: MCQPF). If you have spare funds, that’s where to apply them.

Don’t get me wrong. I’m still very bullish on the long-term prospects of all of these companies, including those that have really run up recently. And as I wrote above, I think a hat trick of a third consecutive year of strong profits is entirely possible, at least for many of them. It’s also likely that the next round of numbers will justify higher buy targets for all of these companies.

It’s also probable, however, that these companies will have some ups and downs on their way to more profits. January was often a good month for income trusts, perhaps because non-Canadians’ appetite for risk is greater at the beginning of the year. But cooling-off periods often followed those strong Januaries, when patient investors could grab some real bargains.

As I’ve said many times, I’m not a market-timer by nature. Rather, I’m best at trying to buy good companies at low prices and ride them higher, as their businesses build real wealth. And that’s the approach I’m going to stick with, even at today’s higher prices for my favorites.

When these companies look cheap relative to their growth and quality, I’ll recommend them as buys. When they appear to have run above where they should be now, I’ll hold off on buying until they either prove their worth or back off. And when companies falter as businesses, I’ll recommend getting out as soon as possible.

Note that if any Canadian Edge recommendation has increased in value enough to unbalance your portfolio, taking a partial profit is certainly in order. You don’t have to sell the whole thing; in fact you shouldn’t as long as the underlying business is strong. But any company, no matter how good it looks on paper, can falter.

The worst mistake investors will make in 2011 is overloading their portfolios to bet on one particular economic scenario such as inflation or an economic relapse that may or may not occur. The solution is to hold a balanced portfolio, where some things will benefit no matter what happens.

The second-worst mistake of 2011 and equally deadly will be allowing a single company to dictate the value of an overall portfolio, simply by keeping it as too large a percentage of the whole.