The Top 3 Canadian Income Stocks

A Special Investor Report from Investing Daily's Canadian Edge

Since Canadian income trusts began trading on the Toronto Stock Exchange (TSX) in 1985, they’ve consistently paid investors some of the highest dividend yields in the world. Until Jan. 1, 2011, Canadian income trusts were like U.S. master limited partnerships (MLP)—pass-through entities that didn’t get taxed at the entity level but only at the investor level. By avoiding the double-taxation inherent in regular corporations, income trusts were able to distribute more cash to unit holders. There were three main types: (1) oil and natural gas production; (2) power and pipeline; (3) real estate investment trusts (REIT); and (4) general business. More than half of the approximately 250 Canadian income trusts were of the oil-and-gas-production variety. Read on to uncover what makes my top Canadian income stocks world-class investments.

Regulatory Change for Canadian Income Trusts

On Oct. 31, 2006, the Canadian government announced that all Canadian income trusts (except Canadian REITs) would lose their tax-advantaged status and be taxed at the entity level—just like corporations—starting in 2011. The trusts and their investors have had more than four years to adjust to the new regulatory regime. Jan. 1, 2011, has now come and gone, and with it, the end of the tax-free status of Canadian income trusts. All trusts (except qualifying REITs) are now considered specified investment flow-through (SIFT) entities that are subject to tax at a rate approximately equal to corporate income tax rates. Consequently, most Canadian income trusts decided to convert to corporations because—with tax rates equalized—a corporate structure provides management much more flexibility than the income-trust structure.

Most Trusts Did Not Cut Dividends Upon Conversion

For more than four years, Canadian income trust investors have worried about the regulatory change but, like the Y2K scare over a decade ago, it turns out the worrying was for nothing. The high-yield legacy Canadian income trusts have established lives on in the new corporations. Many income trusts experienced “cut-less conversions” where they announced that they would continue paying the same dividend amount despite the new tax regulations. The reason is simple: Canada’s federal corporate tax rate is one of the lowest in the world at 15 percent, almost half of that in the U.S. So the additional cost of being taxed at the entity level is a lot less burdensome in Canada than it would be almost anywhere else.

These new Canadian high-income stocks are leaders of a new breed of high-yielding equity never before seen. We still have an impressive set of sound businesses spinning off generous dividends to investors, and that is a victory of fundamental supply and demand. Investors want yield, and public companies have to compete for capital. Distributing a significant slice of cash flow attracts investors, and the practice has the added benefit of instilling discipline on management teams that might otherwise get a little too aggressive when it comes to looking beyond the confines of the business plan.

The outsized dividends paid by these Canadian income stocks dwarf those of a typical U.S. corporation and continue to be much higher than the paltry yields offered by the conventional stocks and bonds most advisors try to shove into clients’ accounts. Rather than enrich themselves with bloated salaries and perks, the interests of Canadian high-income corporations are firmly attached to those of ordinary shareholders. And as the growing wave of low and no-cut conversions proves, they’ve discovered it’s possible to pay out big and grow their businesses by efficient use of capital. It’s certainly not rocket science that investors need yield more than ever before. And these companies have realized they can harness that demand to issue low-cost equity that can fund everything from acquisitions to asset construction. Asset growth, in turn, means cash flow growth, which means a greater ability to pay dividends.

Only the Strongest Canadian Income Stocks Survived

Finally, investors can rest assured that these are companies that have proven themselves in the worst possible conditions over the past several years. Not only were they stress-tested by the economy and credit markets, but they also thrived despite the Canadian government’s restrictions on how they raised capital. That’s something no U.S. company had to go through. And it ensures you that these high-yield stocks have strong underlying businesses with powerful growth prospects. Alberta-based oil and gas producers, meanwhile, will get a double bonus, as the provincial government rolls back royalty rates to get business going again.

It all adds up to windfall gains this year and hefty yields and total returns thereafter—all with much less risk than investing in most U.S. sectors. That’s all the reason anyone should need to buy Canada this year, particularly if you haven’t already.

Canadian Dollar an Added Bonus for U.S. Investors

Investors in Canadian high-income stocks enjoy the added benefit of being paid in Canadian dollars, a currency that should continue to appreciate against the U.S. dollar. Canada is in good shape, with its banks solid and federal budget closest to balance among major countries. Canada was unburdened by a subprime-lending-driven credit bubble, its banks largely avoided risky lending practices and its government and people have been spared the significant costs associated with patching up holes in too-big-to-fail balance sheets. It entered the 2008-09 financial crisis on a positive long-term fiscal trajectory, having turned in a decade’s worth of balanced budgets, and made slow but steady progress whittling away the federal debt. Canada is in an excellent position to extend its global influence, attract increasing amounts of foreign capital and grow at a more durable rate than its developed-economy peers over the next 10 years.

The Canadian dollar climbed a wall of worry in 2012 but managed to exit at virtual parity with the U.S. dollar. And it’s difficult to conceive of any U.S. dollar collapse that wouldn’t benefit Canada’s currency, and therefore the U.S. dollar price of its stocks and U.S. dollar value of its dividends. In fact, dividend-paying Canadian stocks are likely to prove the perfect hedge for U.S. investors if there is a U.S. dollar collapse, all the while generating world-beating yields.

The Canadian “loonie” also provides protection from future inflation because it tracks the price of energy, which is certain to be at the root of any inflation swing. In fact, we think of the Canadian dollar as a “petrocurrency.”

Canadian Energy Stocks Will Outperform

There are two fundamental reasons why energy-based Canadian stocks are likely to outperform other investments in the coming months and years. First, global demand is set to rise exponentially in coming years, as the developing world raises its standard of living. And the industry’s current base of production doesn’t come close to meeting it. Second, the best Canadian energy producers are still extremely cheap. Not only do they trade at huge discounts to the value of their reserves in the ground, but they’re battle tested against the worst possible conditions. Third, their debt, never really very high, is at its lowest level in years. They’re having no problems accessing credit. Virtually every company that could refinance its debt has done so at the lowest interest rates since the 1950s, making a reprise of the 2008 credit crunch nearly impossible.

Yields are still in the high-single-digit/low-double-digit zone and are now protected by extremely conservative assumptions for realized selling prices, which in turn are backed by systematic hedging. Costs are falling, spurred by penny-pinching management but also by the long-awaited drop in production costs due to slack conditions in the energy services business.

To be sure, there are still some near-term risks. Producing natural gas remains a barely profitable proposition at current prices and a serious drag on profits for many high-debt companies leveraged to producing gas. With continuing supply challenges, oil has been a considerably more profitable business this year.

As we’ve said repeatedly to Canadian Edge subscribers, we want to ride this energy bull market all the way up. And as long as our oil and gas stocks are hanging in there as businesses, we're going to stick with them throughout the ups and downs. All Canadian Edge recommendations have demonstrated their ability to weather even the worst storms. All are strong buys and excellent ways to garner high cash flow as we wait on the next leg of this energy bull market to unfold.

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Bull Market in Energy

Given that we are recovering from the worst global recession in 80 years, it’s no surprise that global energy demand has been weak over the past couple of years. This demand weakness has created the illusion that energy is no longer in short supply and that arguments like Peak Oil Theory, so popular just a few years ago, are a bunch of bull. In reality, however, the long-term supply/demand situation just got dramatically worse, as low energy prices basically stymied conservation, use of energy alternatives and new production.

The global economy is returning to strong growth, and increased energy demand is following along for the ride, with the rebound greatest in the developing world as standards of living rise. However, the temporarily weak energy demand caused by the 2008-09 economic crisis has eliminated the desire and wherewithal for the kind of permanent adoption of new technology to reduce energy consumption, such as the massive switch to small cars was to the 1970s.

All require much higher prices than conventional energy to be competitive and are clearly not economic today. As a result, they do little to lessen dependence on the still-much-cheaper oil being produced in hostile nations in the Middle East and elsewhere.

Energy Supplies Should Remain Tight

The energy industry remains very cautious regarding new production. One reason is that, while the price of oil has rallied, natural gas still can’t get above key threshold rates. As a result, producers are still thinking about how they can cut costs to save cash, rather than how to ramp up new output for profit. In fact, when executives from three large Canadian energy producers with sizeable U.S. shareholder bases: Enerplus Corp (TSX: ERF, NYSE: ERF), Pengrowth Energy Corp (TSX: PGF, NYSE: PGH) and Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) were asked at what level of energy prices they would ramp up drilling and distributions again, their unanimous response was that prices would have to stabilize at a much higher level to stir them from otherwise very defensive postures.

As an investor, that’s quite comforting in one sense. It means these energy companies have built in very conservative assumptions to budgeting, hence their current level of distributions. All three also remain focused on holding down debt and keeping costs under control as the best way to outlast weaknesses in the economy. That should help their chances of surviving a low-price environment and staying on track to participate in a recovery.

It also means, however, that in the future, the people running these companies are going to be even more skeptical than usual when it comes to reacting to increases in energy prices.

Canadian energy companies are far more interested in using their cash windfalls to enhance their long-term sustainability by cutting debt and expanding reserves than in increasing output meaningfully. Any additional cash flow they gain from higher energy prices will almost certainly be used first and foremost to trim debt, possibly dramatically. Priority two will again be to expand long-term reserve bases and then return some to long-suffering shareholders, most likely as share buybacks and possibly as special cash distributions.

Only if management is fully convinced that higher prices are here to stay will they really ramp up output. And that’s likely to take a prolonged period of much higher oil and natural gas prices than what we have now. This cautious sentiment is reflected across the industry. The upshot is now that the global economy and energy demand have revived, few are going to really believe better times are at hand. That means supply increases are going to lag demand growth, quite possibly for years.

It generally takes a year to get a producing project back up to speed after it’s been shut, or to bring a new project on stream once a “go” decision has been made. That lag is likely to be a lot longer this time around, as producers’ skepticism restricts them to revving up only their highest percentage projects until they get comfortable about energy prices.

Higher Energy Prices Are a Virtual Certainty

Oil and gas prices are eventually going to take out the 2008 summer highs. In fact, it’s going to take the same factors that ended the 1970s energy bull market, the same factors that have ended every commodity bull market in human history, to restore the balance of market power to energy consumers, where it was during the 1990s.

Those factors are: real demand destruction from permanent conservation; a switch of meaningful energy production capacity from fossil fuels on par with the move to nuclear power in the 1970s; and a genuine discovery of fossil fuel supplies that’s cost-competitive with current conventional sources.

None of the factors are even possible at today’s low energy prices. It will only be possible after oil and natural gas make at least one more extremely profitable run for the roses.

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Our Favorite Canadian Income Stocks

Our analytical basis for recommending companies is a mix of company assets, financial and operating strength, and distributions relative to current prices. We use our proprietary safety rating system, specially created for Canadian Edge, to separate truly undervalued names from the money traps.

Looking through our How They Rate stock screen, the Canadian energy producer that currently is our favorite is ARC Resources Ltd (TSX: ARX, OTC: AETUF), and our favorite Canadian energy distributor is Parkland Fuel Corp (TSX: PKI, OTC: PKIUF). Outside of the energy space, the Canadian income stock we like best is Bird Construction Inc (TSX: BDT, OTC: BIRDF).

Get up-to-date safety ratings, dividend insight, and buy/sell recommendations on over 100 Canadian dividend stocks in the How They Rate Porftolio by joining Canadian Edge risk-free for 90 days.

ARC Resources offers a lower yield than some other energy producers, but it offers by far the best combination of balanced production, conservative finances, healthy reserves, low costs and seasoned management. Parkland Fuel Corp’s acquisition of Elbow River Marketing from AvenEx will add CAD0.16 per share to annual distributable cash flow initially. Combined with the rest of Parkland’s Canada-wide fuel marketing network, the deal offers considerable opportunity for growth. Bird Construction, meanwhile, is the safest and most conservative of the three investments, operating as a general contractor that stands to profit richly this year from government infrastructure projects.

If you own other Canadian high-income stocks, rest assured that a “buy” means a “buy” and that a “hold” means a “hold.” Our Canadian Edge Portfolio picks aren’t the only selections that measure up on our criteria. The Portfolio picks, however, are our favorites because they measure up the best to our criteria, and that’s what we're going to focus on here.

Canadian Income Stock #1
ARC Resources Ltd

Canadian Edge Portfolio holding ARC Resources (TSX: ARX, OTC: AETUF) is one of Canada’s largest conventional oil and gas companies. ARC Resources has an interest in more than 17,000 producing wells from six core areas in western Canada (more than half are in Alberta). 

ARC’s three largest production fields are Dawson (all natural gas), Parkland (mostly natural gas with some oil) and Ante Creek (half gas, half oil). A recent independent study identified ARC’s Dawson field as the lowest-cost unconventional natural gas play in all of Canada. ARC CEO John Dielwart has stated that the Parkland field is “every bit as good geologically as Dawson” and “has a much higher liquids content.” This suggests that ARC’s profit per BOE at Parkland could be even better than Dawson’s, which is eight miles southeast of the Parkland field.

One of the key considerations in the acquisition of an unconventional asset is the ability to efficiently exploit it. These are often complex operations, the geology of which demands sophisticated technology in the hands of experienced workers. In terms of exploration, “tight” (i.e., difficult to reach) natural gas is more comparable to oil sands than to conventional oil and gas. The resource is pretty much known to be there in very large quantities; the solution to the problem of collecting the natural gas in a cost-effective manner requires multiple hydraulic fractures utilizing long horizontal wellbores.

ARC has substantial experience in unconventional horizontal drilling. In July 2005, it drilled the first “multiple-stage-frac” horizontal well in the Upper Montney formation (a natural gas shale area straddling British Columbia and Alberta). The Montney formation (which includes the Dawson and Parkland fields) produces more gas than either the Marcellus or Barnett Shale areas in the U.S. (trailing only the Haynesville Shale), and provides ARC with substantial growth opportunities. In fact, at current production levels, ARC has already grown its energy asset base to the point where it has a reserve life of 14.5 years!

ARC is focused on acquiring natural gas assets for the same reason Exxon Mobil (NYSE: XOM) acquired XTO Energy. Like Exxon Mobil, ARC is responding to the fact of natural gas’s increasing proportion in the global energy pie. Natural gas demand is already growing at three times the rate of oil demand.

The global shift from oil to natural gas is driven by the country that seems to be the force behind all demand-profile shifts: China. The “Middle Kingdom” is in the process of building natural gas terminals to facilitate import of the commodity from Australia. This is part of a move to diversify China’s dependence on coal and oil toward nuclear and natural gas. It has profound implications for Canada, rich in a resource that will soon be traded in a global rather than a regional context.

ARC’s expertise in horizontal “frac” drilling and its growing portfolio of natural gas wells perfectly positions the company to capitalize on the long-term global shift towards natural gas. And it pays a solid and growing dividend that currently yields 5 percent.

With a solid and growing reserve base and on track for continued production gains in the year ahead, ARC Resources is a strong buy. If energy prices do surprise to the upside, this stock will as well.

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Canadian Income Stock #2
Parkland Fuel Corp

Chances are you haven’t heard of Parkland Fuel Corp (TSX: PKI, OTC: PKIUF) unless your business has purchased fuel products in the back country of western Canada. But the company now operates a profitable niche of 622 multi-branded convenience stores and gasoline stations in rural areas coast to coast, stretching into remote reaches of the Yukon and Northwest Territories. The company’s commercial business supplies bulk fuel, propane, heating oil, lubricants, industrial fuels and agricultural inputs under a half-dozen popular brands. Having both commercial and retail segments provides diversification and decreases the seasonality of Parkland’s cash flow. The commercial segment is seasonally strong during the fall and winter months, while the retail gasoline station business is strong during the spring and summer driving seasons.

Parkland Fuel is Canada’s largest independent marketer and distributer of fuels. One of the company’s key competitive strengths is its fleet of trucks, which has direct access to all three major refiners in western Canada and has long-term supply contracts in place. Operating its own truck fleet provides improved control of quality and timeliness of service.

Fuel distribution is a fragmented industry, so growth through acquisition is the norm. Parkland’s recent acquisitions have extended eastward into Ontario and Atlantic Canada. And these additions will translate into surging cash flow as the North American economy continues to recover and winter weather patterns normalize (i.e., get colder). Despite a continual flow of acquisitions, Parkland has had no problem raising cash when needed.

The more the company is able to expand its reach and volumes, the less vulnerable it should be to factors beyond its control such as refining margins and regional competition. Looking ahead, Parkland figures to be a highly profitable company, with room to grow as more major refining companies farm out the distribution part of their business in more remote regions.

Management continues to focus on cost controls, particularly information system upgrades that will better integrate distribution and identify expansion opportunities. This has also required no small effort and cost. But now mostly in place, it should enable even faster growth as the company continues to grow.

The company’s acquisition of Elbow River Marketing from AvenEx will add CAD0.16 per share to annual distributable cash flow initially. More important, however, the deal adds rail car logistics to Parkland’s product and services mix, with a managed fleet of 1,200 rail cars.

This business has operated in the petroleum products sector for 30 years, matching purchases and sales under contracts to eliminate commodity-price exposure. Combined with the rest of Parkland’s Canada-wide fuel marketing network, there’s considerable opportunity for growth.

The fuel distributor’s robust business plan provides many opportunities to boost revenue, cash flow and dividends going forward. The upshot for Parkland’s stock is a combination of robust and reliable growth potential yield selling at a modest valuation and paying a high and sustainable yield north of 6 percent. Combine this high dividend yield with growth-induced capital appreciation, and Parkland stock is a solid bet for annualized total returns of 15 to 20 percent.

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Canadian Income Stock #3
Bird Construction Inc

Bird Construction Inc (TSX: BDT, OTC: BIRDF) operates as a general contractor on building construction and major infrastructure projects, almost entirely in Canada. The company provides construction services to clients in many different industry sectors, including industrial, institutional, retail, commercial, multi-tenant residential, and renovation and restoration. We like Bird as an investment because it generates very predictable cash flows based on its long-term contracts for construction services.

CEO Paul Rabard recently noted that the company’s "strong financial performance is partially based on the execution of contracts relating to infrastructure projects and demonstrates a leadership position that we are developing in this market. We are now beginning to see some signs of a recovery."

Bird has been a huge winner for investors, but there’s still a lot more upside in the company that dominates its infrastructure construction niche. The key for Bird is to continue to win new contracts, preferably from the private sector. The company’s success weathering the 2008-09 debacle and the soft construction market that’s followed has been its ability to make up for a slumping private sector with public-sector contracts.

Such contracts have become more difficult to come by over the past couple years, and margins are lower as well. The beauty of the O’Connell deal is it revived Bird’s private-sector push by adding expertise in industries that are enjoying unprecedented growth, for example mining. That should keep results moving higher in coming quarters.

With no debt and a secure niche, Bird Construction is a solid buy for conservative and aggressive investors alike.

Get up-to-date dividend information and Safety Rating updates on Bird Construction and other top Canadian income stocks by trying out Canadian Edge risk-free for 90 days.

Using Canadian Edge to Generate Consistent Profits Without the Risk

Remember when investors could retire and live well on a modest nest egg? Remember when taxes were only 15% a year, and when you didn’t have to worry about losing your shirt before the closing bell?

That way of life has gradually been taken from you. But Canadian Edge is going to bring it all back. Our subscribers are used to the finest things in life, including investment returns.

Frankly, few of our readers are interested in following the trust markets all that closely. They’re delighted just to find a set of investments that will let them relax, check their holdings every week or two and stroll out to the mailbox once a month to collect their distribution checks.

It’s a lifestyle, and it’s focused more on golf and grandkids than live data feeds and real-time quotes! Our profitable income investment strategies work hard so that you don’t have to.

Many of our loyal Canadian Edge subscribers are retired. These folks want safe and predictable profits, not hype.

Safety is our middle name. Your wild profits will come from tame Canadian income stocks. You simply do NOT need risky investments when you’re safely getting double-digit distributions plus high appreciation.

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Yes, we’ve enjoyed tremendous success at Canadian Edge. But we're absolutely convinced that we’ll achieve stunning investment returns during the next 24 months and pocket greater profits than EVER before!

The Canadian stocks we cover have crushed the competition. The 10 recommendations we made in our charter issue in 2004 are up 175%. Meanwhile, the S&P 500 is up just 18.9%.

Canadian Edge readers have racked up some pretty impressive capital gains: 177% in natural gas…

• 159% in power production…
• 415% in construction…
• 289% in socially responsible oil and gas…
• 264% in industrial chemicals…
• 458% in international energy production…
• 532% in pipelines…
• 453% in transportation…
• and 290% in real estate.

The income stocks that have been around for a decade or more have produced spectacular gains for investors. Every time we travel and break bread with our  subscribers of Canadian Edge, the stories are told and retold. 

The timing for Canadian dividend stocks couldn’t be better. Uncover all of our top picks by joining Canadian Edge today.

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Our proprietary safety rating system, covering every single one of the Canadian income stocks worth covering, gives investors the extra level of assurance that’s so helpful when branching out into the unfamiliar.

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• FLASH ALERTS supplement the monthly analysis, focusing in-depth on trends and events that can affect your holdings. Any urgent buy/sell advice will be emailed to you instantly. But these are solid investments that rarely require urgent action.

• TAXES, CURRENCY CONVERSIONS AND MORE. How will U.S. tax authorities treat your Canadian holdings? How will international currency fluctuations affect their prices? Are oil and gas stocks backed up by reserves in the ground, and how long before they go dry? Our White Papers explain these important, sometimes confusing fundamentals—in plain English.


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