Canada's Prospects Now

07/28/2008 12:00 am EST


Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

Gordon Pape, publisher and editor of The Canada Report and Internet Wealth Builder, shares his views on the loonie, energy trusts, and the Canadian market.

Q. Do you think the Canadian dollar is a good investment right now?

A. The "loonie" (after the bird on the $1.00 coin) has been trading at slightly below par with the US dollar for some time. It is unlikely to move much higher in the near future as there is a major international oil crisis.

The loonie has appreciated more than 60% against the US dollar since 2002, putting a lot of pressure on Canadian exporters and the manufacturing sector. The federal and provincial governments, as well as the Bank of Canada, will make every effort to keep the loonie from moving much higher-consistent, of course, with free market economics.

I would not advise speculating on a further increase in its value. Over the longer term, I expect it to stabilize around 95 cents to $1.00.
Q. Several advisors have recently said that the actions of the Canadian government to reduce the tax benefits from owning Canadian energy trusts are now built into the prices of these trusts. Do you think that is correct?

A. In most cases, no. Many of the trusts, especially in the energy sector, are still being given premium valuations by the market. The theory is that many investors are willing to pay more for cash flow. An example is Canadian Oil Sands Trust (TSX: COS.UN) and Suncor (TSX, NYSE: SU). Both are major oil sands producers, but COS trades at a higher multiple than Suncor primarily, it appears, because it carries a yield of 8.5% vs. Suncor's 0.4%.

I believe that as we get closer to the implementation date of the new tax (January 1, 2011) we'll see downward moves in the share prices of many of these trusts to reflect the likelihood of distribution cuts when the tax kicks in.

However, there are a number of variables that can affect this situation. If oil prices rise to the $175-$200 range between now and 2011 (not an impossibility by any means), the positive impact on the bottom line of these trusts could largely offset the tax bite. Also, most are accumulating tax pools that will reduce the impact of the new tax for a while. And some, such as Vermilion (TSX: VET.UN), derive part of their income from foreign operations. Profits that are taxed offshore won't be subject to the new Canadian tax.

Q. Would you recommend that non-Canadian investors continue to buy Canadian energy trusts?

A. A 'qualified' yes, due to the above risks. However, the yields are very attractive and there is also the possibility of mergers and takeovers at premium valuations as we approach 2011. The Canadian oil patch is flush with cash, and some of the smaller players are almost certain to be snapped up.

Q. What are the most important criteria in evaluating trusts? And which trusts do you think have the best prospects for the rest of 2008?

A. Focus on good reserves, strong balance sheets, and proven management. Good quality assets are always worth owning. Our number-one energy trust recommendation currently is Canadian Oil Sands. (TSX: COS.UN). The price has dropped somewhat with the decline in crude oil, so this looks like a good entry point. We also have buy recommendations on Vermilion (TSX: VET.UN) and energy services company Keyera Facilities Income Fund (TSX: KEY.UN).

Q. Are there any particular energy trusts that you would advise investors to stay away from right now?

A. I've never been a fan of Harvest Energy Trust (TSX: HTE.UN, NYSE: HTE). Their numbers are soft-on a per unit basis; cash from operating activities was actually down in the first quarter, despite strong oil prices. And I am not convinced that the 2006 acquisition of a refinery in Come-by-Chance, Newfoundland was a wise use of its assets.

Q. Gordon, what do you think the specific risks are in the Canadian markets currently?

A. Its narrow base. It's been very strong in recent years, but with a few exceptions like Research in Motion (Nasdaq: RIMM), that strength rests on two pillars: financials and resources. Canadian banks and insurance companies were not hit as hard as their US counterparts by the subprime mess, but neither have they escaped unscathed-as of the close of trading on July 24th, the S&P/TSX Capped Financials Index was down 13.6% year-to-date, despite a recent rally.

Consequently, it's been left to the energy and materials sectors to carry the TSX, and now they are showing signs of having peaked, at least temporarily. Unless that situation changes quickly, I think the TSX will trend downward for the rest of this year. That doesn't mean there won't be profits to be made, of course, but it will all come down to stock selection. I would not buy the whole index at this point in time.
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