Calendar year 2007 ranks as one of the most turbulent in memory for Canadian income trusts. Most striking were the massive divergences in performance between individual trusts.

On the plus side, including a double-digit currency gain, more than two-thirds of the Canadian Edge universe turned in double-digit total returns. So did roughly the same percentage of CE Portfolio picks, which were up an average of 11.4 percent for the year.

Even leaving out the Canadian dollar’s solid showing, two-thirds of How They Rate and Portfolio picks were up for the year. That was despite some of the most difficult market conditions in memory for any sector, as I pointed out in the December Feature Article. And some three-dozen trust takeovers awarded investors with near-term gains of 20 to 50 percent.

On the negative side, anything tied to natural gas got its head handed to it. That included not only producers of the fuel but any trust relying on income from servicing the industry.

Dividend cuts were another kiss of death. And more than a few trusts inside and outside the energy patch entered death spirals, unable to operate as dividend-paying businesses without easy access to capital markets.

As I pointed out at the beginning of last year, the key to trust returns is the health and growth of their underlying businesses. That was the difference between big gains and disasters in 2007, and it’s the key to 2008 as well.

Ironically, most investors remain fixated on trust tax policy and what will happen in 2011. That will be as big a mistake in 2008 as it was in 2007.

The Halloween 2006 announcement—i.e., that trusts will be taxed as Canadian corporations beginning in 2011—was fully priced in a month later. That means, if the law stays the same, it’s just status quo. There’s no future doomsday and no real additional risk.

There’s still the possibility of government retrenchment, even if the ruling Conservatives stay in power past 2011. Last month, for example, the government dramatically relaxed restrictions on foreign investment by REITs. That ensures virtually all REITs will qualify for favorable tax treatment past 2011. It also enables the larger, stronger REITs to invest strategically in the US, taking advantage of weakness here as well as the buying power of a strong Canadian dollar.

Trusts also aren’t getting credit for their ability to avoid 2011 taxation. The average Canadian corporation pays just 6 to 7 percent of its real income in taxes. Well-run trusts should be able to find as many angles, particularly if a large percentage of income comes from outside Canada (not taxed) or if they generate a large amount of noncash expenses that shelter cash flow.

As for the possibility that trust taxation be overturned, that’s no where in the equation. Any rollback—such as a cut in the maximum tax rate to 10 percent, as proposed by the opposition Liberal Party, or 10-year grandfathering, as proposed by the Bloc Quebecois—would create a profit windfall.

The bottom line is any new developments on the trust taxation front are a positive for investors, whether it’s some macro effort by a government suddenly aware of falling tax revenues or the market recognizing an individual trust’s dodge. Fundamentally, whether this happens or not is beyond our control. But 2007 proves we can win big with trusts even if nothing happens, provided we focus on owning the best businesses. 

The same thing holds for the future of the Canadian dollar. As a petro currency, the loonie follows the price of oil and will increasingly as oil sands output becomes ever-more important to meeting global demand. (See Canadian Currents.)

As long as oil remains in a bull market, the Canadian dollar should remain in a general uptrend against major consumer nations such as the US, with ups and downs along the way. And the oil bull market will continue until we see real 1970s-magnitude conservation, alternatives, a new conventional reserves discovery and a demand-crushing recession.

In other words, the Canadian dollar should continue to play a positive role for trust returns in 2008, lifting the US dollar value of distributions and share prices as it did in 2007. Note this doesn’t apply to trusts that are vulnerable to a falling US dollar, particularly those manufacturing for export to the US.

A rising Canadian dollar, however, isn’t something we want to count on anymore than we should developments in taxation or mergers to produce winning returns. Rather, the key is what it always was: focus on buying and holding trusts backed by healthy, growing businesses.

Trusts that survived and thrived in 2007 definitely qualify, particularly those that increased their distributions at least once since Halloween 2006. (See Feature Article.) So do others that have proven their businesses are strong and sustainable in the worst market conditions.

Starting at the end of the month, we’ll get another batch of trust earnings with adjoining information for the full year. Oil and gas trusts will publish extensive data on reserves. Other businesses will provide extensive information on debt covenants, particularly important to review given the tightened credit markets.

The new data will only further underscore the differences between trusts’ performance as businesses. That, in turn, will further widen the divergence of investment returns they’ll generate, making 2007 a prologue for 2008.

As I pointed out in the December Feature Article, I expect macro conditions to improve for Canadian trusts across the board. As this month’s Feature Article makes clear, merger and takeover activity should accelerate. And at some point, a bottom for the US economy will send investors back to high-quality, high-yield investments.

Good businesses will continue to outperform weaker ones. And as long as the bad times last on the macro front, they’re the only trusts guaranteed to survive, let alone keep paying outsized dividends.

The table “Portfolio Returns” shows how my picks performed in 2007 in terms of total return—distributions plus change in US dollar share price. Below, I break them down by groups based on performance and discuss how the past is likely and not likely to prove a prologue for 2008.

Red-Hot

Even leaving out the Canadian dollar’s salutary effect, six Canadian Edge Portfolio recommendations scored double-digit gains in 2007: Bell Aliant Regional Communications Fund (TSX: BA-U, OTC: BLIAF), Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF), GMP Capital (TSX: GMP-U, OTC: GMCPF), Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF), Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

All six are Conservative Portfolio holdings that dodged the meltdown of Canada’s natural gas business. All six also boosted distributions in 2007 and show every sign of hiking payouts even more in 2008 and beyond.

Energy Savings has announced a special distribution to be paid out over the first three months of 2008. The total payout of 38 cents Canadian a share will be 50 percent cash (or 6.333 cents Canadian a month) and 50 percent in units of the trust.

That’s in addition to the regular distribution, which was hiked more than 20 percent since Halloween 2006. US shareholders will be withheld from 15 percent of the total. Per the trust’s instructions, the units portion isn’t included in income or cost basis for US investors.
 
Energy Savings remains on track for more robust distribution growth in 2008 as it gains market share on both sides of the border. That spells more share price gains as well. Buy Energy Savings Income Fund up to USD18 if you haven’t already.

Pembina Pipeline also hiked its distribution by more than 20 percent during the past 14 months. With the oil sands Horizon Pipeline project slated to begin generating returns in the third quarter of 2008, more robust growth is ahead.

The trust has slated CAD223 million for expansion in 2008, including additions to its conventional pipeline business. Buy Pembina Pipeline Income Fund up to USD18.

GMP Capital is firing up an asset management business with an initial investment of CAD100 million. That promises to keep dividend growth going at a double-digit pace in 2008. The trust is also a prime takeover target for any outside investment house anxious for a pole position in the Canadian markets.

Buy GMP Capital up to my new target of USD25. Note the trust is paying a special cash distribution of 65 cents Canadian per share this month.

Keyera Facilities Income Fund has completed an internal reorganization that should enhance its ability to pay bigger distributions in 2008 and beyond. That will preserve tax pools for use after 2011.

It’s also paid a special cash distribution to shareholders of 35.29 cents Canadian per share. Buy Keyera Facilities Income Fund—whose expanding asset base remains immune to troubles elsewhere in Canada’s energy patch—up to my new target of USD20.
 
Yellow Pages continues to successfully migrate its business to the Internet while maximizing cash flow from its traditional print pages operations. The trust has increased its distribution twice already since Halloween 2006, and further boosts are a lock in 2008.

The revamping of the recently acquired Auto Trader is another plus. Yellow Pages Income Fund is a buy up to USD16.

Bell Aliant’s distribution growth in 2007 was modest. Instead, its strong recovery from late-2006 lows came as investors gravitated back to its utility-like reliability and takeover appeal once the private capital takeover of parent BCE was completed.

From a business standpoint, advances by former parent Aliant should spur more broadband growth in 2008, which increases the ability to boost dividends. Buy Bell Aliant Regional Communications Fund up to USD33.

Dollar Aided

Another 10 current Canadian Edge holdings scored double-digit 2007 total returns in US dollar terms. Five are Conservative Holdings: AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF), Artis REIT (TSX: AX-U, OTC: ARESF), Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF), Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) and Macquarie Power & Infrastructure (TSX: MPT-U, OTC: MCQPF).

AltaGas and Macquarie both boosted distributions modestly. But the real key to their solid performance was the growth of their underlying businesses.

AltaGas’ biggest challenge this year is completing the acquisition of Taylor Natural Gas Liquids LP. But it will also benefit from numerous other projects in 2008, including additions to its wind power fleet and gas-gathering assets. Buy AltaGas Income Trust up to USD28.

Artis closed on CAD177.4 million in previously announced property purchases, all of which are in the country’s hottest markets and should immediately begin adding to cash flow available for distributions. The trust’s focus is likely to remain on growing the business in 2008, but dividend growth becomes more likely the further the payout ratio drops. Artis REIT is a buy up to USD18 for those who don’t own it already.

Arctic Glacier continues to take advantage of the depressed US dollar to boost its ice manufacturing and sales in this country. Atlantic Power has done the same, adding to its stake in a Florida cogeneration plant last month.

Both have dividends well shielded from 2011 taxation–Arctic for its US operations and Atlantic for its unique tax structure as an income deposit security. Arctic Glacier Income Fund is a buy up to USD14, Atlantic Power Corp to USD12.

Macquarie increased its distribution by 1.94 percent last month. That’s the first fruit of its successful investments in carbon-neutral power generation and long-term care since I initially recommended it in May 2007. I look for more in the year ahead as the company manages costs and enjoys higher rates for output.

Management expects the full-year 2007 payout ratio to come in at 95 percent, not including benefits from the sale of a wind power loan asset. Yielding well more than 10 percent, Macquarie Power & Infrastructure is a buy up to USD12.

Both of my closed-end mutual funds posted Canadian dollar-aided double-digit total returns. EnerVest Diversified Income Fund (TSX: EIT-U, OTC: EVDVF) managed the feat despite seeing its share price fall to a 21.9 percent discount to net asset value (NAV). The discount is a result of investor dissatisfaction with management’s focus on expansion rather than buying back shares to narrow the discount.

But the gap guarantees a huge gain for EnerVest shares when investor sentiment on trusts turns for the better. Yielding well more than 16 percent based on its market price, EnerVest Diversified Income Fund is a buy up to USD7.

Select 50 S-1 Income Trust (TSX: SON-U, OTC: SFYIF) trades at a much smaller discount to NAV of around 5.5 percent, likely owing to a simpler portfolio and policy of buying back shares. The trust’s special distribution of 77 cents Canadian is another plus. Select 50 S-1 Income Trust is a buy up to USD13.

The remaining trusts rewarding US investors with double-digit gains hail from the Aggressive Portfolio.

Last month, Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) became the only conventional oil and gas producer trust to increase distributions since Halloween 2006, boosting its payout 12 percent. Management credited steady growth in production and reserves, conservative financial policies since its inception in January 2003 and a “strengthening commodity price environment” in its key markets.

Vermilion’s strong performance in what have been the worst of macro conditions for other energy producers is also a result of 75 percent reliance on oil, which makes it too volatile to be a Conservative Portfolio holding. But the dividend increase is a sign management intends to remain a generously paying entity long after 2011. Buy Vermilion Energy Trust up to USD40.

ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) have also proven themselves as paragons of sustainability in a turbulent energy market, despite being considerably more reliant on natural gas sales than Vermilion. Peyto paid a special cash distribution of 35 cents Canadian per unit this month, reflecting its success and need to maintain tax-free status in 2007.

Both trusts are a lock to maintain current levels of distributions in 2008, even if natural gas prices remain depressed. And if gas recovers, they’re strong candidates to join Vermilion as dividend boosters. ARC Energy Trust is a buy up to USD23; Peyto Energy Trust is a buy up to USD20.

We also garnered a double-digit gain from recently sold TimberWest Forest Corp. TimberWest completed the sale of 9,700 hectares of forest land to the Capital Regional District for CAD64.7 million last month, a move that should shore up cash reserves. And it plans other real estate sales that should enable it to maintain its distribution for the time being.

By the second half of 2008, however, dividend safety will depend on the health of the timber market in the US and by extension abroad. Until we get a better read on that situation, I’m steering clear for now.

Around the Waterline

Five trusts were down in Canadian dollar terms for the year but up on the currency gain against the US dollar. They didn’t get much credit in a fear-driven market, perhaps partly because only RioCan REIT (TSX: REI-U, OTC: RIOCF) boosted its distribution.

But the quintet did do something considerably more important: They proved their underlying businesses are still solid. That should point the way to a better showing in 2008, even if the Canadian dollar lags its 2007 pace.

Two in the group are highlighted in High Yield of the Month: Provident Energy Trust (NYSE: PVX, TSX: PVE-U) and RioCan REIT. Of the remaining trio, two are from the Conservative Portfolio.

Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF) continues to yield 11 percent despite high business sustainability, strong finances, adequate dividend coverage and asset growth. The trust was chosen by Manitoba Hydro to proceed to the next phase of developing 165 megawatts of wind power facilities, the output of which would be sold to the provincial authority under long-term contracts at escalating prices. The company’s next task is to provide satisfactory project information, and, if successful, it would then enter rate negotiations.

Algonquin also repowered a natural gas power plant in California last month and has plans to add more capacity to sell to US utility PG&E. And it concluded the sale of interests in US landfill gas assets for USD11.34 million for a gain. Algonquin Power Income Fund is a buy up to USD9.50.

Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) has continued to expand its base of cash-generating assets, picking up properties in several provinces over the past year, including the energy patch. The REIT has also made several accretive sales of noncore properties and maintained very high occupancy rates.

That, plus a much healthier market for residential real estate in Canada than in the US, has enabled the REIT to hold value, even as rivals to the south have sunk. Canadian Apartment Properties REIT remains a solid buy for long-term income up to USD20.

As I pointed out in the December High Yield of the Month, Aggressive Holding Enerplus Resources (NYSE: ERF, TSX: ERF-U) shares have been weak during the past couple months mainly because of the Focus Energy Trust (TSX: FET-U, OTC: FETUF) purchase. That’s no reflection on solid Focus but rather on investors’ tendency on both sides of the border to sell the acquirer in mergers.

In any case, this is one deal that should come up big for Enerplus when it’s completed later this quarter. In the meantime, solid Enerplus Resources shares are dirt cheap up to USD50.

Five other trusts were barely below the waterline for 2007 in US dollar terms. As a group, they were a very mixed bag, including one trust that increased its distribution during the year—Northern Property REIT (TSX: NPR-U, OTC: NPRUF)—and one that reduced its payout, Advantage Energy Trust (NYSE: AAV, TSX: AVN-U).

The other three suffered from extreme weakness in their respective industries. Already hit by concerns about natural gas prices on its earnings, Penn West Energy Trust (NYSE: PWE, TSX: PWT-U) has further sold off during the process of completing mergers with Canetic Resources (NYSE: CNE, TSX: CNE-U) and Vault Energy Trust (TSX: VNG-U, OTC: VNGFF). The good news is both mergers still look set to wind up by early next month at the latest.

Meanwhile, the trust’s pilot project to extract more energy from wells using carbon-dioxide flooding is on track after getting the OK from Alberta provincial authorities. It also inked a new credit deal that adds significant new resources at a bargain price, despite a tightening credit environment.

Once the mergers are wound up, I look for strong recovery in this still-solid trust. Penn West Energy Trust is a buy for those who don’t already own it up to USD38.

Trinidad Energy Services Income Trust (TSX: TDG-U, OTC: TDGNF) continues to enjoy steady results from its mostly US-based rig fleet, even while its rivals founder. (See Tips on Trusts.) The shares have been all over the place but remain my favorite way to play the battered energy service industry. Buy Trinidad Energy Services Income Trust up to USD18 if you haven’t already.

Finally, TransForce Income Fund (TSX: TIF-U, OTC: TIFUF) continues to boost its transportation franchise with solid acquisitions. The yield of 17 percent is pricing in a substantial distribution cut, despite strong dividend coverage and a 3.9 percent dividend increase this fall.

My view is this: If the market is right and transport conditions worsen to force a dividend cut, it’s already priced in. And if this trust continues to weather the storm, there’s a big capital gain on the way in 2008. TransForce Income Fund is a buy up to USD14 for risk-averse investors who don’t already own it.

The Big Losers

The key to avoiding the worst of a challenging market is to dodge the really big losers. To a large extent, we’ve been able to do that in Canadian Edge, though unfortunately not entirely.

Of the current Portfolio holdings, three suffered double-digit losses even after factoring in Canadian dollar gains. And the portfolios were hit with significant losses in two positions sold during the year as well: Precision Drilling (NYSE: PDS, TSX: PD-U) and Primary Energy Recycling (TSX: PRI-U, OTC: PYGYF).

I’m still not tempted by Primary, which may or may not have solved its asset management troubles. However, as I noted when I recommended selling it last month for a tax loss, I’m still a long-term bull on Precision.

The trust announced an aggressive 70 percent increase in its capital spending budget for 2008, including construction of 19 new super series land drilling rigs. It’s also decommissioned 11 drilling rigs and 16 service rigs in its Canadian fleet as part of an effort to cut out unprofitable operations.

Those moves should be very positive for the trust’s turnaround effort, even if the Canadian gas market continues to lag. I’m upgrading Precision Drilling to a buy again under USD16 but only for aggressive investors and only with the understanding that a real recovery in the shares is going to take time. Note that the trust will pay a special cash distribution of 16 cents Canadian a share on Jan. 15.

The three biggest current portfolio losers from 2007 are Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), Newalta Income Fund (TSX: NAL-U, OTC: NALUF) and Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF). To date, only Paramount has actually reduced its distribution. But the other two are definitely pricing in deep future cuts, as is Paramount with its 19 percent-plus yield.

Why are we still in these trusts? The main reason is all three have the potential to gain back all the ground they lost last year and a lot more.

As I pointed out in the Dec. 13 flash alert, Boralex’s distribution is basically a cash flow stream from a portfolio of heretofore well-run, carbon-neutral power plants operated by solid parent Boralex. There’s no danger of Chapter 11, and if water flows return to normal levels on the rivers serving its hydro plants, cash flows will return to normal.

I hate the loss, but with the shares selling below book value and management still maintaining the distribution, there’s no reason to sell. In fact, Boralex Power Income Fund is a buy for those who don’t own it up to USD8.

Newalta didn’t earn its distribution in the third quarter. But as I pointed out in the December issue, management did hit all the key metrics for efficiency and profitability and continued to diversify away from energy patch-related operations. As a result, it’s on track to cover the payout in 2008.

And once management proves it can keep paying, the shares are headed back to where they were in the first half of 2007–in the high 20s. Newalta Income Fund is a buy up to USD25.

Finally, Paramount remains a rank speculation. It’s not going anywhere but down until there’s a recovery in natural gas prices and Canadian energy patch activity. Not even survival is assured if gas prices fall far enough, let alone the current level of dividends.

But this is the most leveraged way to bet on a gas recovery, and for that, Paramount Energy Trust suits my purposes as a buy up to USD10.

Note that I strongly advise against the strategy of averaging down in this or any other investment for that matter. That’s the surest way to blow a hole in your portfolio as long as this challenging market lasts.