Editor’s Note: In Brief is the executive summary of the September 2011 issue of Canadian Edge. Please use it as a guide to reading the issue. — RC

This January, I posited several reasons why Canadian stocks and Canadian Edge picks in particular could score a “hat trick”–a third consecutive year of outsized gains to go on top of the outstanding returns of 2009 (65.5 percent) and 2010 (40.3 percent).

The first was the benign resolution of four years of worry about 2011 trust taxation, coupled with Canada’s tumbling corporate tax rates. The second was continued robust global demand for the country’s natural resource bounty and the positive effect on the Canadian dollar. Third and most important was a return to dividend growth, as strong companies got used to operating as corporations and returned a portion of record cash flows to shareholders.

Offsetting that was what I perceived as the single biggest threat to the market in early 2011: rising investor expectations, as reflected in record-high prices for many CE Portfolio picks.

My view then was the positives still outweighed the negatives, and that a third year of solid returns was likely. I also added admonitions to periodically take partial profits to rebalance holdings, to avoid stop losses, to buy only below buy targets and never to “average down” in a falling stock.

As it’s turned out, whether you have gains or losses thus far in 2011 for your Canadian Edge stocks depends entirely which you own.

The S&P/Toronto Stock Exchange Income Trust Index–which now consists solely of real estate investment trusts (REIT) and a handful of income trusts that didn’t covert to corporations–has returned about 14 percent for the first eight months of 2011.

However, the broader Canadian market, as represented by iShares MSCI Canada Index Fund (NYSE: EWC), is off about 5 percent.

Even the strongest of the 38 current Portfolio Holdings faced some selling in August. But 10 still have a year-to-date total return (dividends plus capital growth) of 20 percent or better. Conversely, seven are underwater more than 20 percent for the year, including now-unloaded Yellow Media Inc (TSX: YLO, OTC: YLWPF). And the rest are roughly evenly divided between winners and losers, with a slight bias to the upside.

The upshot is we’re still in the game for a hat trick in 2011. But it’s far from a sure bet.

On the plus side, we are seeing a return to dividend growth, slowly but surely. On Aug. 9 Davis+ Henderson Income Corp (TSX: DH, OTC: DHIFF) became the seventh former trust in the Portfolio to boost its post-conversion payout. And five other companies are good bets to follow in the next few months.

Corporate borrowing rates are at record lows, and underlying global demand for natural resources remains robust. And the high investor expectations we saw in early 2011 have vanished along with lofty valuations for stocks.

The chief negative is global financial markets, which remain extremely volatile and prone to panic whenever the news sours. According to the latest data, US economic growth is still slow and jagged, just as it’s been since the markets bottomed in early 2009. But worries of a reprise of the 2008 market crash/credit crunch are more palpable than ever.

The key concern now is Europe’s continuing sovereign debt crisis and the possibility that it could set off a “systemic” crash of the global financial system. Ironically, Canada’s financial system appears as strong as ever. All of its major banks except Royal Bank of Canada (TSX: RY, NYSE: RY)–which took a CAD1.513 billion writedown of its now-sold US assets–topped expectations with robust fiscal third-quarter 2011 earnings gains. And even Royal Bank had healthy results in its home country.

The Canadian dollar has given some ground since mid-July. But it also remains stubbornly above parity with the US dollar. That’s a stark contrast with 2008. And, as I pointed out last month, it means the loonie is no longer purely a petrocurrency but is being viewed a safe haven.

That being said, no stock is immune from a full-scale panic. Investors are still selling everything and running to US Treasuries when the economic news worsens, just as they have since 2008. Despite last month’s downgrade of Uncle Sam by Standard & Poor’s, the yield on 10-year Treasury notes is its lowest ever at just 1.94 percent.

Canada’s 10-year note yield is also at an all-time low, and so are the country’s corporate borrowing rates. Such low financing costs are another stark contrast with 2008. Moreover, companies have used them to virtually eliminate refinancing risk. Even if conditions should tighten, they’re protected against a reprise of that year’s credit crunch.

Even the safest stocks are likely to be volatile in coming weeks, as Europe’s financial woes play out. And any company reporting bad news is likely to take a hit. But low financing costs are a major reason to stay positive on dividend-paying companies backed by strong underlying businesses.

The aftermath of 2008-09 showed that as long as underlying businesses stay strong and dividends are paid, recovery from near-term market losses is assured. Meanwhile, investor worries have again knocked the expectations bar down a few rungs. In fact, anything short of a 2008-09 reprise in the next couple months could set off a solid end-of-year rally. That would earn us the hat trick of a third consecutive up year in 2011.

Hang in there.

Portfolio Action

I’m taking advantage of the drop in oil prices to add a high-quality producer stock to the Aggressive Holdings this month, Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF). It’s also a High Yield of the Month pick (see below) and is trading nearly 20 percent off the all-time high reached earlier this year. I’m also moving EnerCare Inc (TSX: ECI, CSUWF) to the Conservative Holdings, reflecting strong second-quarter 2011 earnings and much improved dividend coverage.

I’ve adjusted buy targets on several holdings to reflect higher value as companies. Atlantic Power Corp (TSX: ATP, NYSE: AT) is a buy up to USD16, thanks to a new lending agreement that enhances financing flexibility for its acquisition of privately held Capital Power LP. Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF) is a buy up to USD22 after reporting solid progress on new power plant construction. Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) gets a buy target bump to USD20 on its solid second-quarter results. So does Northern Property REIT (TSX: NPR-U, OTC: NPRUF), which is now a buy up to USD30 despite the likelihood it will have to abandon its stapled-share structure due to a change in government rules.

See Portfolio Update for all the details.

High Yield of the Month

High Yield of the Month features the two best buys for September. If you’re starting a portfolio, buying HYOTMs each month is one good strategy, provided the picks meet your own risk/reward preferences. As was the case last month, I’ve highlighted a new addition to the Aggressive Holdings and a current Conservative Holding paying a yield of more than 8 percent.

The new addition is Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF), a fast-growing, oil-weighted energy producer with a major presence in the Bakken Shale on both sides of the border. The company has been on my radar screen since 2009, when it converted from income trust to corporation without cutting its dividend.

Crescent grew its liquids output by 21 percent in the second quarter of 2011 from year-earlier levels. Oil and natural gas liquids now account for 90 percent of overall output, and a planned 25 percent boost in capital spending this year promises to keep production growing at a rapid pace the next few years. The company has also closed two acquisitions thus far in the third quarter that add to output and are complementary to its land position in North Dakota. Funds from operations were up 35.7 percent, and operating expense per barrel produced fell 5 percent.

The stock is off roughly 20 percent from the high set in March due to investor concern about a further drop in oil prices. That gives us a chance to buy it with a yield of nearly 7 percent. My buy target for Crescent Point Energy remains up to 48.

The Conservative Holding I’m highlighting is Artis REIT (TSX: AX-U, OTC: ARESF), a diversified real estate investment trust that’s taken advantage of low financing costs to rapidly grow its portfolio the past few years. Second-quarter 2011 revenue surged 68 percent and funds from operations grew 71.5 percent from 2010 levels, even as occupancy rose to 95.6 percent and debt-to-book value was cut to 50.7 percent. Funds from operations per share moved 11.5 percent higher.

Management has continued its aggressive acquisition strategy this year as well, even as it pays a yield of more than 8 percent. My buy target is up to USD15 for Artis, which now actually trades at just 99 percent of book value.

Feature Article

This month’s focus is power and pipeline stocks, the segments of the Canadian economy and the CE Portfolio best suited to resist a recession.

To be clear, I don’t expect to see such a slide for the Northern Tiger, which even in 2008-09 was barely scratched by global financial turmoil. But should the worst occur in coming months these companies will still have no problem paying robust dividends of between 5 and 10 percent, several of which have already been raised once this year.

Their services are essential, and demand for them is inelastic. Their finances are secure, and their primary customers are extremely large energy companies and Canadian government entities, which, unlike their counterparts in the US, are in the pink of health.

All of my picks are also poised for robust long-term growth. And, thanks to recent market weakness, they’re cheaper than they’ve been in many months.

Canadian Currents

Associate Editor David Dittman takes a look at companies in the How They Rate coverage universe that have suspended or eliminated dividends. Some did so to free up cash flow to fund significant asset expansion; that’s what Advantage Oil & Gas (TSX: AAV, NYSE: AAV) did in March 2009, when it used the imminent transition imposed by the Oct. 31, 2006, trust tax announcement as an impetus for a full-fledged reorientation of the business.

Advantage is now a high-growth, high-volume gas producer. Operating results validate the wisdom of management’s choice; the market has been less sanguine, but prospects for the company remain bright. Advantage isn’t necessarily among The Bungled and the Botched, but it’s experience is a good starting point for separating those suspenders/eliminators that made proactive decisions that will provide long-term stability for the business–and perhaps the reinstatement of dividends–from those that are circling the drain.

Tips on Trusts

This section features short bits on a wide range of topics. For more evergreen and tutorial items, see the Subscribers Guide.

Dividend Watch List–There were no dividend cuts in the Canadian Edge How They Rate coverage universe over the past month. A number of closed-end mutual funds I track, however, have reported first-half numbers that merit caution. With very few exceptions, investment income covered a far lower percentage of distributions than in previous periods.

Covering a portion of distributions with gains on asset sales and margin is standard practice for most closed-end funds. But Precious Minerals & Mining Trust (TSX: MMP-U, OTC: PMMTF) actually posted negative investment income in the first half of 2011, including capital gains. As a result the entire payout was a return of capital (ROC). So was the payout for EnerVest Energy & Oil Sands Total Return (TSX: EOS, OTC: EOSOF).

Distributions are the purview of management and the board of directors, and a fund can elect to pay a return of capital dividend indefinitely. But any fund paying entirely from ROC should be considered an aggressive bet on a specific sector, rather than a steady income investment. That applies to both of these funds.

Both EnerVest Energy & Oil Sands and Precious Minerals & Mining are now on the Watch List and rate holds. Here’s the rest of the list.

Brompton Stable Income Fund (TSX: VIP-U, OTC: BVPIF)–Advice: SELL. The payout ratio for the first half of 2011 blew out to 302 percent of investment income.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Advice: Hold. Second quarter results were solid and the payout ratio dipped to 90 percent. The business appears to be stabilizing but the margin for error is still low.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Advice: SELL. The fallout from the company’s disastrous investment in the US and current attempt at retreat continues to pressure earnings, though the payout ratio in the second quarter was a manageable 81 percent. Encouragingly, management states it doesn’t anticipate changes to its dividend at this time.

FP Newspapers Inc (TSX: FPI, OTC: FPNUF)–Advice: Buy @ 5. The payout ratio in the second quarter was under control at 79 percent. The core print and advertising business continues to decline, but the stock is still OK for risk takers.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Advice: Hold. The company’s payout ratio came down sharply thanks to higher oil prices, but drilling on its lands is still weak.

Interrent REIT (TSX: IIP-U, OTC: IIPZF)–Advice: Hold. The payout ratio dipped to 75 percent in what is a seasonally strong period for apartment REITs, due to low heating costs. Encouragingly, occupancy improved sharply to 95.1 percent. This one may actually come off the Watch List in a couple quarters, though as I wrote last month there are lower-risk alternatives yielding more.

Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–Advice: Buy @ 5. Second-quarter numbers support the dividend, and the third quarter seems in line with management expectations as well. But this one is a very aggressive bet on natural gas prices, not a dividend stock.

Ten Peaks Coffee Company Inc (TSX: TPK, OTCL SWSSF)–Advice: SELL. This company has been battered by the strong Canadian dollar year after year, and there’s nothing in second-quarter numbers suggesting any relief.

Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Advice: SELL. I hate giving up on a stock that’s fallen this far. But as I said when I dumped Yellow last month, the latest dividend cut is a tacit admission by management that long-held plans to convert the print yellow pages clientele to the company’s Internet advertising has not met projections. Meanwhile, this month the chief financial officer announced he’ll step down.

Bay Street Beat–How the Canadian analyst community views the CE How They Rate coverage universe, including our favorites.

Tips on DRIPs–Reinvest your dividends paid by NYSE-listed Canadian companies–in some cases at a discount and without paying commissions.

How They Rate

The CE Safety Rating System is based on six operating and financial criteria. Companies meeting all six criteria are rated my highest rating of “6.” “0” is the lowest rating, indicating companies that meet no safety criteria. Safety criteria, described in the text below the How They Rate table, are as follows:

• One point if the payout ratio meets “Very Safe” criteria for the sector.
• One point if the payout ratio is not “At Risk” based on the criteria for its sector.
• One point if debt-to-assets ratio meets “Very Safe” criteria for the sector.
• One point if the company’s debt maturing before Jan. 1, 2013, is less than 20 percent of its market capitalization.
• One point if the company’s primary business is recession resistant. Qualifying varies from company to company, though virtually all Electric Power and Energy Infrastructure companies qualify, while no Energy Services companies do.
• One point if the company has not cut its distribution over the preceding five years.

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–Distributors from propane to package ice.
• Business Trusts–A range of businesses involved principally with consumers.
• Real Estate Trusts–All qualified Canadian REITs and real-estate related corporations.
• 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–Canadian banks, investment houses, and other trusts and corporations providing support to these businesses.
• 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–These trusts and corporations ship freight and move passengers by bus, truck, rail or air.

Coverage Changes

There’s one new addition to How They Rate this month, First Asset Pipes & Power Income Fund (TSX: EWP-U, OTC: FAPPF). This fund was reviewed in the July 2011 Feature Article and holds a large number of Portfolio companies. It starts out as a buy up to USD8, though I still prefer holding individual companies to funds.

Advice Changes

Here are advice changes. See How They Rate for changes to buy targets.

Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF)–SELL from Buy @ 2. It looks like the price of survival is extreme dilution, as second-quarter earnings fell well short of expectations due to lower sales and a spike in costs.

Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–Buy @ 13 from Hold. Second-quarter earnings indicate the company has gained traction, particularly a 5.8 percent boost in same store sales. The yield is 8.5 percent after the recent 9.5 percent dividend increase.

Cinram International Income Fund (TSX: CRW-U, OTC: CRWFF)–SELL from Hold. Second-quarter results were much worse than expected, severely reducing the odds that unitholders will retain any value here.

FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy @ 5 from Hold. Second-quarter earnings were good enough to earn this company a buy recommendation as a speculation. Growth in the digital business seems to be offsetting losses of traditional revenues from subscriptions, supporting the yield of more than 12 percent.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Hold from SELL. Near-term pressure on the dividend is reduced by a 33 percent surge in second-quarter funds from operations. Equally important, the stock’s price has come off sharply.

Homeq Corp (TSX: HEQ, OTC: HEITF)–Hold from SELL. A drop in share price coupled with generally solid second-quarter earnings earn an upgrade for Canada’s leading seller of reverse mortgages.

Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF)–SELL from Hold. The company still has CAD23 million in debt to refinance by the end of the year, and the current market capitalization is just CAD9.5 million.

Interrent REIT (TSX: IIP-U, OTC: IIPZF)–Hold from SELL. Second-quarter numbers were vastly improved across the board, and the dividend looks like a much better bet to hold now.

NAL Energy Corp (TSX: NAE, OTC: NOIGF)–Hold from Buy @ 15. Second-quarter earnings were weaker than expected because of reduced output as well as lower natural gas prices. There are better alternatives in energy.

New Flyer Industries Inc (TSX: NFI-U, OTC: NFYIF)–Hold from Buy @ 10. The planned dividend cut is priced in already, but second-quarter results indicate the company faces an uphill battle in coming months.

Noranda Income Fund (TSX: NIF-U, OTC: NNDIF)–Hold from SELL. Management is now considering reinstating a dividend and has settled its refinancing needs. I may eventually consider a buy recommendation depending on the dividend decision.

Precious Minerals & Mining Trust (TSX: MMP-U, OTC: PMMTF)–Hold from Buy @ 12. The first-half 2011 payout was entirely return of capital. This is still a good way to bet on mining stocks, but the risk to the dividend has grown.

Premium Brands Holdings Corp (TSX: PBH, OTC: PRBZF)–Buy @ 17 from Hold. The stock yields more than 7 percent after summer selling, and a dividend boost is possible after strong second-quarter numbers.

Ratings Changes

Here are ratings changes, reflecting second-quarter 2011 numbers.

ACTIVEnergy Income Fund (TSX: AEU-U, OTC: ATVYF)–To 3 from 4. The payout ratio based on distributions of holdings has surged.

Bird Construction Inc (TSX: BDT, OTC: BIRDF)–To 4 from 6. The payout ratio spiked up in the second quarter, but record backlog and accretion from the O’Connell merger likely point to another dividend increase in early 2012.

Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–To 2 from 0. Second-quarter earnings were robust, indicating the underlying business has gained traction in a tough environment. Moreover, management has clarified a very positive dividend policy of paying out essentially all distributable cash flow and increased the distribution by 9.5 percent as well.

Brompton Stable Income Fund (TSX: VIP-U, OTC: BVPIF)–To 2 from 4. The payout ratio for the first half of 2011 has soared to 302 percent of investment income.

EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF)–To 3 from 4. The payout ratio for the first half of 2011 based on distributions from holdings has surged. It’s still a solid fund, but I’d like to see better coverage in the second half.

EnerVest Energy & Oil Sands Total Return (TSX: EOS-U, OTC: EOSOF)–To 2 from 4. The payout ratio for the first half of 2011 was entirely return of capital.

Futuremed Healthcare (TSX: FMD, OTC: FMDHF)–To 3 from 4. The second-quarter payout ratio has ballooned out to 338 percent after an 8.3 percent drop in cash flow.

Homeq Corp (TSX: HEQ, OTC: HEITF)–To 4 from 3. A drop in the payout ratio to 41 percent in the second quarter earns an upgrade for Canada’s leading seller of reverse mortgages.

Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF)–To 0 from 2. The downgrade in rating comes from debt, as there’s still CD23 million to refinance by the end of the year. Failure would mean reorganization and a likely shareholder wipeout.

Interrent REIT (TSX: IIP-U, OTC: IIPZF)–To 3 from 2. The payout ratio has come down and now earns the apartment landlord an additional point in the Safety Rating System.

For More

How They Rate has automatically updated US dollar unit/share prices, dividend payment rates in US dollars, yields, most recent dividend dates, dividend frequency and debt-to-capital ratios. Note that our quote service sometimes includes special annual distributions along with the regular monthly payments. How They Rate also includes several free links. Clicking on the Toronto Stock Exchange (TSX) symbol will now take you directly to the Google Finance page for every company in the How They Rate coverage universe.

Clicking on the US symbol of a company takes you to a chronological listing of every Canadian Edge and CE Weekly article in which that trust has been featured. You can also use that page to access articles on other trusts by typing in the relevant exchange and symbol in the “Search Query” box at the top of the page.

For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site for a range of information on dividend paying equities. The Web site www.sedar.com is an online library of documents filed by trusts with the Canadian equivalent of our Securities and Exchange Commission. The Toronto Globe & Mail features the “Globe Investor” section with all the latest news. Dominion Bond Rating Service is the pre-eminent credit rater in Canada. The Bank of Canada has 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.

How They Rate can now be accessed several places on the Home Page. The Income Trust Tax Guide has backup to file distributions as “qualified dividends.”

Roger Conrad
Editor, Canadian Edge