Trusty Trusts

10/28/2005 12:00 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

Having correctly forecast a summer "shakeout" in Canadian income trusts, Roger Conrad now says, "You can now build a diversified portfolio yielding more than 10% and growing distributions at double-digit rates." Here's his outlook.

"When I first launched Canadian Edge last year, I was attracted to trusts for one basic reason: They paid massive dividends that they increased over time as their businesses expanded. Butt as 2005 progressed and prices continued to rise, I was increasingly frustrated by the inability to find trusts that presented long-term value. Many investors adopted the view that no price was too high to pay, particularly those involved in oil and gas. We saw trusts that were yielding 10% or 12% a year ago, rise in price to where their yields dropped to 7% or 8%.

"Now, we're seeing the mirror image of that environment. No matter how bullish the news coming out of the trusts themselves, many investors seem to be of the mindset they can't get rid of their trusts soon enough. The point of this discussion isn't to remind you I called an exact top in the trust market. Rather, the point is perspective. We're in the trusts for income and capital gains based on distribution growth. And that applies to the trusts when their share prices are falling just as much as it does when they're going up.

"Why are trusts prices falling so sharply? The Canadian government is apparently continuing to deliberate on what's to be done on the issue of ‘tax leakage’ caused by corporations converting into trusts. One option being discussed is to impose an additional levy on trust distributions. Nothing is sure at this point. But based on what's being proposed now, the most likely course is going to be something moderate that will keep trusts extremely attractive.

"The most striking impact of the rumors of possible actions is they've at least temporarily overshadowed a far more significant development. S&P has decided to include trusts in the benchmark S&P/Toronto Stock Exchange Index. Basically, anyone who benchmarks the Canadian stock index will now have to load up on trusts. This will further improve the transparency of the market, and should provide some support to prices. More important, it's an effective vote of confidence on the part of S&P, which no doubt deliberated the tax-related concerns in consultation with a great many insiders on the issue.

""At this point, the other two factors, the risk of rising interest rates and falling energy prices, seem well priced-in to most trusts. The oil and gas trusts we've been recommending appear to be pricing in a drop to $40 or less per barrel of oil and $7 or so for natural gas per million BTU. We may get there, but we're a long way from either level. Best of all, the trusts themselves seem to have prepared their dividends for such an eventuality over the past year, which is one reason the best have been able to pump up dividends.

"It's never much fun to watch an investment lose value rapidly. And I wouldn't discount the distinct possibility that prices will go lower before they bottom out. For one thing, uncertainty about the taxation of trusts is going to linger until there's some definitive information about what's going to happen. That could well take several months and the market hates uncertainty. Of course, at some point, all the worst case scenarios will be priced in and we're probably nearly close to there now.

"The key, however, is to keep your perspective. Simply, we're in this thing for the income. The lower prices go, the better prices you're going to be able to get to buy trusts paying big dividends and increasing them at robust and reliable rates. The key to whether you want to keeping owning a trust in a down market is how its business is performing. If the business is in good shape, hang in there and possibly buy more whenever prices come down. If the business is deteriorating, get out, no matter where the price is.

"Provided you've chosen good trusts, you're going to get a high and rising stream of income that will push up the prices of your holdings over time. That's why we got into these things in the first place. That's still their primary appeal. And as they come down in price, they are becoming better investments and values are emerging. So we are getting better buying opportunities. We are focusing on those trusts with the best underlying fundamentals. We want those that are continuing to grow and increase their dividends.

"For example, ARC Energy (CA:AET.UN Toronto) announced an 18% boost in its monthly dividend. That was on top of a 13.3% hike during the summer. Better still, evidence points to comparable increases in 2006 and beyond, even if oil and gas prices moderate. Based on selling prices and costs for the third quarter of 2005, the trust's payout ratio should actually drop to the low 50% range when its numbers are released late this month. In addition, it's completed a drilling program that will allow it to boost production by nearly 10% above current levels by the end of the year. Despite this extremely good news, ATC shares fell sharply and are now well under my buy price. That price action has been mirrored in other trusts reporting strongly positive news, including Enerplus (ERF NYSE), which increased its dividend again by 13.5% at the end of last week.

"In addition, our other portfolio members have very healthy businesses. That's a point that should be underscored as third quarter earnings start to come in over the next few weeks. We have seen accretive acquisitions made by Altagas (CA:ALA.UN Toronto), Superior Plus (CA:SPF.UN Toronto) and Transforce (CA:TIF.UN Toronto). We have seen strategic moves at Big Rock Brewery (CA:BR.UN Toronto), Pembina (CA:PIF.UN Toronto), and Timberwest (CA:TWF.UN Toronto). And we have seen dividend increases at both Superior and Yellow Pages (CA:YLO.UN Toronto). If these moves are any indication, this is going to be a very strong quarter indeed for our these recommended trusts."

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