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In Canada we trust ... an American vote for income trusts

One of the USA’s leading experts on Canadian income trusts has re-assessed the situation — and he’s far from ready to pack it in.

On more than one occasion these past few weeks, we have noted that interest in income trusts has not flagged in recent months. Quite the opposite.

The tax-inspired sword of Damocles that is hanging over the head of trusts has certainly shaken up the market, but it has not come close to finishing it off.

One of the key factors that will affect the future of the trust market is the ongoing interest of American investors. A good many investment greenbacks have poured into Canadian income trusts in recent years. Are more on the way, or less?

With this in mind, we take great interest in the opinion of one of America’s foremost experts on income trusts. Mr. Roger S. Conrad has followed Canadian markets for many years — and made himself a leading expert in income trusts even before the trust market boomed.

After the Halloween massacre

Writing in the latest issue of Personal Finance, Mr. Conrad acknowledges that the world has changed since the so-called “Halloween massacre” that occurred in the House of Commons last fall.

But he also states that the best trusts are in “recovery mode.” Despite all the uncertainty, “we’ve also seen takeovers priced well above pre-deal prices, strong names moving to all-time highs and even the weakest gaining ground.”

Mr. Conrad duly records the problems that have beset many oil and gas royalty trusts, the failure to block the Conservative tax scheme and proposed new regulations in the U.S. that may alter the taxation of trust distributions. Then he moves on to what he sees as the most important point.

“Trusts with vibrant cash-generating businesses,” he says, “have attracted a whole new group of buyers — private capital — and they’re buying Canada in record numbers.”

This adds a new element to the mix. “For individual investors, trusts’ primary appeal has always been high, sustainable and growing distributions. Private capital is similarly interested in businesses that generate the high, sustainable and growing cash flow needed to pay those distributions.”

“But unlike you, they can minimize any prospective taxes with a variety of means, including loading trusts with debt.”

Only one viable strategy

Mr. Conrad adds that private capital buyers are no more immune from mistakes than the rest of us. But you can bet they’ve done their homework.

“The fact that they’re buying trusts across the board in record volume is rock-solid confirmation that the best of these are not only solid cash generators, but that they’re dirt cheap as well.”

But don’t count on on a private capital buyout as an exit strategy, he adds, or on a reversal of Canadian government policy. “Both are certainly possible, and either would produce windfall gains.” But Mr. Conrad’s advice has not really changed. The only viable strategy for investing in trusts “is the same one we’ve espoused since we started recommending them early in the decade: Buy and hold only those that can produce superior returns on their own, without any help from forces beyond their (and our) control.”

Strongest economy in the developed world

Mr. Conrad has narrowed his focus further in recent months. “We’re concentrating on those trusts that are preparing their businesses to pay us big distributions well beyond 2011 anyway, assuming they’ll ultimately be taxed as corporations.”

And he adds this comforting thought. “Trust taxation didn’t change the fact that Canada’s economy is currently the strongest economy in the developed world, by virtue of its solid resource base.”

Mr. Conrad has a series of recommendations for his readers. Interestingly enough, in the short time since this issue of Personal Finance was printed, most of these trusts have come close to or reached the author’s U.S. price targets. Perhaps that’s no coincidence.

But that should not stop us from seeing which trusts Mr. Conrad trusts. Nor indeed from giving them serious consideration, if American investors are getting aboard. Two are Real Estate Income Trusts (REITs) which are exempt from the 2011 tax. They are Canadian Apartment Properties REIT (TSX-CAR.UN) and Northern Property REIT (TSX-NPR.UN).

Atlantic Power Corp. (TSX-ATP.UN) is exempt from the 2011 tax as an Income Participating Security (IPS). The company “combines a debt security with equity to pay a superior dividend that’s approximately 60 per cent debt and 40 per cent qualified dividend.”

Perennial favourite Yellow Pages Income Fund (TSX-YLO.UN) makes the list, as do two energy trusts with sustainable reserves, Vermillion Energy Trust (TSX-VET.UN) and Provident Energy Trust (TSX-PVE.UN). Then there are two refrigeration firms that generate more than 70 per cent of their business outside Canada and should have ample wealth to counter future taxes: Arctic Glacier Income Fund (TSX-AG.UN) and Versacold Income Fund (TSX-ICE.UN).

So for all the swords of Damocles and Halloween massacres, income trusts have not yet been cut down to size. Apparently what doesn’t kill them makes them stronger.