In This Issue

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THE OIL PRICE WILL RISE.. AND FALL

Oil prices touched another record last week as traders fretted about Hurricane Katrina and its potential disruption of supplies from the Gulf of Mexico. Meantime, a prominent economist, Jeff Rubin of CIBC World Markets, jumped in with a prediction of US$100 a barrel oil in our future.

No wonder investors are antsy and wondering what to do. Last week I received yet another e-mail from a member asking for my take on where oil and gas prices will go from here.

Well, I?m no economist (the best I can claim is an A in Economics 101 in college). But in one sense, the answer is a no-brainer ? prices will go up! The basic laws of economics make that a certainty. Demand is increasing, supply is diminishing. There is no other logical conclusion, at least over the longer term.

The short term is another matter, however. We?ve seen how oil prices can turn on a dime based on the latest news. A new tropical storm threat in the Gulf of Mexico? Prices rise. Higher than expected inventories? Prices fall. New tensions with Venezuela? Prices rise. OPEC to pump more oil? Prices fall. No one in their right mind would try to predict where oil prices will be one month from now, given all these variables.

What is clear is that high oil prices will inevitably have an impact on businesses and on consumers. Already many companies, including giants like Wal-Mart, are complaining of profit margins being eroded by rising energy costs. The high price of gasoline and home heating fuels will squeeze family budgets and force spending cuts elsewhere. The ripple effect will result in increases in everything from electricity bills to bus fares.

The short-term result will be falling demand. People will curtail the use of the family car and more will turn to public transit. Money that might have gone to a new chair for the living room or a winter coat will be diverted to pay the higher natural gas bill. Consumer spending will slacken, leading to production cut-backs. That in turn will reduce energy demand.

As the cycle takes hold prices will drop, assuming supply remains constant, and the market valuation of energy stocks will follow. As oil pulls back to the US$50 range or below we?ll see relief at the gas pumps, where the latest news bulletins seem to have an immediate effect. As the prices decline further, demand will begin to pick up again and the cycle will start all over.

So where are oil and gas prices going? Up, then down, then up again is my best guess. This has always been a volatile sector. There?s no reason to believe that anything has changed.

What should you do as an investor? It depends on your time horizon. If you are an active trader, you should continue to take some profits as prices move higher. Don?t sit on all your gains, especially if energy has become overweighted in your portfolio. There is no way of knowing where the top of this particular cycle is going to be.

Longer-term investors may prefer to live with the ups and downs, knowing that over time all good-quality energy stocks will increase in value. This is an especially useful strategy with companies or trusts that have long-life reserves and that provide decent cash flow in the form of dividends or distributions.

The time will come when the wells will run dry, of course. But it won?t happen for many years, probably not within our lifetimes, because the higher the oil price, the more economic it becomes to tap into unconventional sources. Remember, it wasn?t that long ago that people said the Alberta oil sands would never be economical!

So decide on which strategy you want to pursue and stick with it. You?re almost certain to make money. ? G.P.

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TOM SLEE SAYS TO BOARD THE TRAINS

Contributing editor Tom Slee is with us this week with a look at an industry that is very much in the news these days ? Canada?s railroads. Here are his comments.

Tom Slee writes:

Twenty years ago railways were a sunset industry. People thought of trains as museum pieces, dinosaurs. Trucks, the wave of the future, dominated the haulage business and pipelines were going to move the bulk commodities across the continent. It was time to put the iron horse out to pasture. No use fighting progress, right? Wrong! These days a lot of those trucks are stranded on our clogged highways. The vaunted pipeline feeder system has never materialized. Railways, meanwhile, are booming. In fact, I suppose you could call them a sunrise industry.

In fairness, some analysts see the railway renaissance as a short-lived phenomenon. They think that this is still an old-fashioned cyclical industry where a few companies, such as CN Rail, have done well. According to them, investors should take their profits and run. Others, me included, disagree. We believe that there has been a fundamental change in the North American transportation world, a basic shift to rail that offers substantial investment opportunities.

As far as Canadians are concerned, the game changed in 1995 when the government privatized CN Rail and unleashed a sleeping giant. Six years later, Canadian Pacific spun off Canadian Pacific Railway and gave us some real competition and a choice of stocks. However, as this is a continental industry the tracks don?t stop at the border and for the real sea change we have to go back to 1980, to the Staggers Rail Act in the U.S. That legislation, modeled on the Airline Deregulation Act, replaced a regulatory structure which had been in place since 1887 and almost bankrupted many railroads. It was like a breath of fresh air. All of a sudden, American railways could decide when and where to operate their trains and how much to charge.

Of course, it hasn?t all been smooth sailing since then. There have been several false starts but the cost cutting, equipment upgrades, and consolidations are finally paying off. In fact, several Wall Street observers regard 2004 as the year the U.S. railroads came into their own. The railways moved more freight than any other year in history, intermodal (container) volume topped 10 million trailers for the first time, and the leading companies purchased or leased 1,121 new locomotives, a 90% increase over 2003. As a matter of fact, in some regions companies were unable to handle the demand, a new experience for them, and there was congestion on lines running into Pacific coast ports in both Canada and the States. Union Pacific, for example, was caught short of equipment and crews.

Perhaps even more encouraging, the good times have rolled into 2005 and everything points to this being solid, sustainable growth. The flood of freight to and from China may subside but companies are already planning for the lift-off in trade with India. The American Association of State Highway and Transportation Officials (AASHTO) predicts that North American domestic freight will double and international freight will double or triple over the next 20 years. I guess you could call that a rising tide and it comes at a time when the trucking companies are struggling. Railways are stepping into the breach.

All of this means that the railroads are finally able to impose rate increases and these, unlike higher volumes that involve more costs, go straight to the bottom line. As a result, six of the seven major North American railroads beat analysts? earnings expectations in the second quarter. I find this particularly encouraging. For years we have watched these companies desperately slashing expenses in order to create some nominal earnings growth, with CN Rail the only outstanding performer. Now we have improved profit across the board.

In effect, U.S. economic growth skated the railways on-side. The original networks, laid in the 19th century, had enormous spare capacity that was never utilized because an aggressive trucking industry siphoned off the freight and people chose to travel by air. The railways languished and had little incentive to upgrade or expand their facilities. Transportation needs, however, continued to increase and now, almost overnight, it seems the entire system is under stress. All the slack has been used up.

According to a recent AASHTO study, our highways, already bottle-necked and overloaded, are unable to meet the projected demand. That, along with soaring fuel costs, is going to take the starch out of the trucking companies.

Railways too are bumping up against capacity. The West Coast system is seriously congested. In this case, though, the pressure works to the railroads? advantage. They have raised their rates and imposed surcharges to offset energy prices. Railways also have some room to increase efficiency. Trains are becoming longer and heavier. Locomotives already pull three times the load of their predecessors in the 1950s. Rearrangements of tracks and re-routing will provide more room. Most important, railways can selectively increase their rail networks and, in doing so, fatten their bottom lines.

It means that the leading railroads have evolved into a growth industry. With our transportation system stretched and demand increasing at an expected GNP growth rate of about 3%, carriers can increase rates, continue to shed their still excessive overhead, and extend their tracks. Of course, there are going to be peaks and valleys. Cyclical commodities still account for a large part of the volume. Despite this, earnings, especially for the better-managed railroads, should trend higher.

The railways have another plus. The boom times are unfolding just as their cut-throat competitors have lost their edge. For years analysts believed that in order to survive the railroads would have to recapture markets from the trucking companies. That is no longer the case. The hauliers are struggling with mounting costs as well as a shortage of drivers and, of course, they are unable to build new highways. As a result, most of the new and some of the existing business is shifting to the railways. Ironically, the trucking industry has become one of intermodal rail?s biggest customers. Strange times indeed!

So what does it all mean for small Canadian investors? Well, I think that several of the railway stocks look particularly attractive right now. For instance, Burlington Northern Santa Fe (NYSE: BNI) is currently trading at US$54.30, about 12 times next year?s expected earnings of US$4.40 a share. It?s relatively cheap. With freight revenues growing at 15% and a 78% operating ratio (the proportion of revenue consumed by expenses) the company is on a roll and we could see the stock at US$65 or more next year.

This is a good choice for investors looking for a U.S. transportation stock for their portfolios and I am adding it to my Buy list.

My first choice, however, is Canadian Pacific Railway with CN Railway a close second. It?s not because they are Canadian, but because they have the most upside potential. See my updates for the reasons why.

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UPDATES

CANADIAN PACIFIC RAILWAY (TSX, NYSE: CP)

Originally recommended on Feb. 26/01 (IWB #2108) at $26.45. Closed Friday at $45.90 (US$38.34).

Canadian Pacific Railway turned in an excellent second quarter and then some. Profit jumped 47% year-over-year from $83.7 million or 53c a share in 2004 to $123.2 million, or 77c. Operating results, stripped of all non-recurring items, were up 34% to 87c a share. CEO Bob Ritchie said that ?it had been a long, hard slog but now there is some sunshine?.

He had good reason to be happy. Revenues grew in five of CPR?s seven divisions during the second quarter. Coal jumped an astonishing 48%. The lucrative intermodal business was up 19%. Meanwhile, operating expenses were contained despite a 35% year-over-year increase in fuel costs. As a result, the company?s all-important operating ratio fell 2.5% to 75.5%. To put that into perspective, CSX Corporation, the largest rail network in the Eastern United States, has an 83% operating ratio.

There was more good news. The company announced the renewal of a major long-term contract with the potash producers and this takes care of the coal and potash shipments that CPR needs to utilize its expanded western corridor. Management has already signed a five-year deal with Elk Valley Coal, the world?s largest producer of metallurgical coal.

Looking ahead, the company expects to make about $3.20 a share this year but I think that it will do better. We could see $3.30. The real opportunities, though, are in 2006. The outlook for grain is encouraging, the company will participate in increased potash prices, and its network expansion should start paying off. Earnings could exceed $4 a share.

Action now: Buy Canadian Pacific Railway at $45.90 with an increased target of $55. I have set a revisit level of $42.


CN RAIL (TSX: CNR, NYSE: CNI)

Originally recommended on May 6/02 (IWB #2218) at $51.90. Closed Friday at $80.07 (US$66.85).

At CN Railway, the second-quarter numbers were also impressive, the sort of results we have come to expect from North America?s most efficient railway. Profit for the three months ended June 30 increased to $416 million ($1.47 a share), up 30% from $362 million ($1.13 a share) in 2004. Analysts had been looking for $1.34.

Here again, as with all the railways, it?s good to see solid top-line growth. Revenues were up 10%, almost 15% if you exclude foreign exchange adjustments. Cash flow from operations was $730 million, triggering an announcement that the company is going to buy back 16 million of its common shares. Costs rose a miniscule 3% as lower labour expenses offset rising oil prices and CN?s operating ratio fell to a record 61.2%, the best in the industry. To quote one leading analyst: ?Wow!?

But a word of caution. CN Rail was involved in five accidents during August including the serious spill at Wabamun, Alta. The unions have complained that these incidents resulted from cost cutting and skimping on maintenance. In other words, they claim the record operating ratio comes with a price. In fact, the company has an excellent safety history and its accidents per million train miles fell from 2.44 in 2001 to 1.71 last year. Nevertheless, it’s something I’m going to watch very closely.

The question is ? where does this lean machine go from here? The answer, I think, is onward and upward, albeit at a slightly slower rate. There is little room for more cost cutting but revenues should continue to grow as a result of demand and rate increases. The ace is CN?s acquisition program. Its recent purchases of Great Lakes Transportation and BC Rail were a neat fit. Most railway mergers involve a lot of overlap and duplication. Great Lakes and BC Rail added length to the system and the deals should add 35c to earnings this year and 45c in 2006.

CN remains by far the best railway. The only reason CPR is my first choice at the moment is because it has more room to improve.

: Buy CN Railway at $80.07 with an increased target of $94. I will revisit the stock if it dips to $72.


HOME DEPOT (NYSE: HD)

Originally recommended on April 26/05 (IWB #2516) at $36.02. Closed Friday at $39.81 (All figures in U.S. dollars.)

Elsewhere, Home Depot beat nearly everybody?s estimates by posting a 14% jump in second-quarter profits. Thanks to additional product lines, expanded self-checkout services, and better inventory controls, the company earned $1.77 billion, equal to 82c a share, compared to $1.55 billion (70c a share) a year earlier.

HD continues to focus on improving same-store sales and opening new outlets on a very selective basis. This is a far cry from the old expansion at any cost policy. At the same time, Depot remains on the acquisition trail. Last month it purchased National Waterworks, a contractor supply business, for $1.35 billion. It?s a major step into the professional contractor space; a move to cushion economic cycles.

The fundamentals are in good shape at Home Depot and the company should make $2.60 a share this year, up 15% from $2.26 in 2004. The bad news is that the stock has been buffeted by concerns about Wal-Mart and some poor U.S. housing numbers. I see the present weakness as a buying opportunity.

Action now: Buy Home Depot at $39.81 with a target of $48. I have set a $35 revisit level.


BOMBARDIER SERIES 4 PREFERREDS (TSX: BBD.PR.C)

Originally recommended on March 8/04 (IWB #2410) at $25.01. Closed Friday at $20.65

Bombardier is again in the news, with announcements that 20 of its plane orders from Delta Air Lines are no longer endangered and Austrian Railways has ordered 60 rail vehicles worth US$223 million. The slow recovery continues. In fact, the long-term outlook is actually improving. The company should make about 18c a share next year, its aerospace backlog has inched up to $10.4 billion, and the restructuring plan is on track.

All of this means that the preferred dividends are safe for now, although a lot could go wrong, and remain attractive for investors able to assume some risk who are seeking above average income.

Action now: Buy the Bombardier Series 4 Preferreds at $20.65 to yield 7.5%, equivalent to 9.6% from a bond after adjustment for the dividend tax credit.

– end Tom Slee

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THE BAY?S NEW REWARD ? READ THE FINE PRINT!

An intriguing press release came through my e-mail box last week. Just in time for the Back to School season, it proudly announced that participants in The Bay?s rewards program will now be able to exchange 100,000 points for a $100 contribution to a new registered education savings plan (RESP) opened through Canadian Scholarship Trust Plan (CST) or Heritage Education Funds.

The initiative ?raises the bar on customer rewards programs?, the release proclaims. The Bay?s CEO, George Heller, is quoted as saying his company is ?proud to be able to give all Hbc Rewards members the opportunity to start an RESP today.?

It all sounds very noble. But before you rush to set up a plan, take a close look at the prospectuses. CST?s, for example, runs to a mind-boggling 80 pages. In order to get that $100 from Hbc Rewards, you have to commit yourself to paying what could add up to a lot of money.

For example, if you decide to open a CST Group RESP (for children up to age 12) that will cover all your family members, there?s an enrolment fee of $200 a unit. The more you want to contribute, the more units you have to purchase. There are some complicated tables and examples included in the prospectus that will take some work to figure out. There are also some annual fees on top of this.

When you start contributing to the plan, all the money you put in (yes, all) is applied against your enrolment fee until half the amount due is paid. That means you are not putting any money aside for your youngster in the early stages ? you are simply paying fees. Once half the amount owed has been paid off, 50% of your contribution goes towards the fees until they are discharged, with the other half to savings. The CST prospectus gives this example:

?If you are contributing $50 per month and the total enrolment fee is $500, the enrolment fee would be paid as follows:

?? first five months: $50 per month would go to the enrolment fee (this equals $250, which is one-half of the enrolment fee).

?? subsequent 10 months: $25 per month would go to the enrolment fee (this equals $250, which fully pays the enrolment fee) and $25 per month would go to the Principal.

?? subsequently $50 per month would go to the Principal.?

So after 15 months you would have paid out $750 of which $500 would have gone to fees and $250 to your child?s account. You will get your enrolment fees back down the road, if you make all the required contributions and if your child receives all four education grants from the trust.

It?s also important to understand what happens if you decide not to continue with the program. If you cancel after 60 days, you will lose all the enrolment fees you have paid as well as any interest earned. You will get your principal back, once the costs have been deducted.

The Family and Individual plans for children 13 or older have different rules and much lower fees. The minimum initial contribution is $150.

The terms and conditions for Heritage Funds may differ somewhat. See their website.

Scholarship trusts have provided financial assistance to a lot of students over the years. But opening an RESP with one of them involves a significant financial commitment for a family. So don?t rush into it just because you can get $100 from Hbc Rewards. There?s a lot to consider. Do your homework. ? G.P.

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INCOME TRUST SCORECARD

RBC Capital Markets reports that more than 72% of income trusts met or bettered their forecast results in the second quarter. The figures were based on cash flow from operations (CFFO). Trusts that were within 5% of forecast on either side were considered to have met expectations. Those that exceeded or fell short of the 5% window were classified as ?Better than forecast? or ?Below forecast?.

Exactly half the 84 reporting trusts met their forecast, with 22.6% coming in higher and 27.4% underachieving. RBC noted that there was no clear pattern to the weak performers but all five restaurant trusts did better than predicted. ? G.P.

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UPDATES


CANADIAN UTILITIES (TSX: CU.NV)

Originally recommended by Gordon Pape on May 1/00 (IWB #2017) at $18.88 (split adjusted). Closed Friday at $36.39.

Investors received a pleasant surprise on July 28 when Canadian Utilities announced a two-for-one stock split, effective Sept. 15. The shares started trading on a split-adjusted basis on Thursday, Aug. 25. The split is being done in the form of a stock dividend, with one extra share for each one you currently own. All shareholders of record as of Aug. 29 will benefit.

Three days earlier, the company released second-quarter results. They showed operating earnings of $50 million (79c a share), up from $45.1 million (71c a share) for the same period last year.

The stock?s September dividend of 55c a share will be paid on a pre-split basis. Future dividends will be half that amount, unless an increase is announced.

This company has done very well for us over the past five years and I continue to regard it as a core position.

Action now: Hold. ? G.P.


LOBLAW COMPANIES (TSX: L)

Originally recommended by Gordon Pape on June 17/02 (IWB #2223) at $58.60. Closed Friday at $69.50.

Second-quarter results from Loblaw continue to show progress despite on-going restructuring costs which nibbled away at the bottom line. The big grocery retailer said net earnings for the period to June 30 were $211 million (76c a share, fully diluted) compared to $197 million (71c a share) during the same period in 2004. Management reported that 2c had been knocked off the earnings per share figure by expenses relating to an extensive restructuring program which it is estimated will cost $90 million by the time it is completed in 2007. Of that, $70 million will be recognized in expenses this year. Sales for the quarter were up 6% although same-store sales were disappointingly flat.

The stock pays a quarterly dividend of 21c a share, with the next payment due on Oct. 1.

Action now: Loblaw remains a Buy. ? G.P.

RIOCAN REIT (TSX: REI.UN)

Originally recommended by Gordon Pape on April 20/98 (IWB #9814) at $10.90. Closed Friday at $21.50.

RioCan?s second-quarter results continued to show why this is Canada?s blue-ribbon REIT. Recurring distributable income (RDI) came in at a record $140.3 million (72.7c a unit), up 15% from $121.8 million (67.8c a unit) for the comparable period in 2004. However, both net earnings and funds from operations (FFO) were down because of the redemption of some of the trust?s unsecured debentures at a cost of slightly more than $20 million. This was fully expensed in the first half of the fiscal year.

At the same time, the trust announced it is increasing the monthly distribution to 10.75c a unit ($1.29 a year), up from 10.5c previously. For long-time members who bought RioCan shares when I first recommended them back in 1998, this means your yield will now rise to 11.8%. This is exactly how a top-quality REIT should perform ? stick it in your portfolio and watch the cash flow and the market value rise over time.

Action now: Hold. ? G.P.

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YOUR QUESTIONS

What about TimberWest?

Q – I was an employee of TimberWest for 13 years and then was severed in 2002 along with 50 other employees. During my employment, I had purchased shares and trust units through payroll deduction and rolled those directly into an RRSP. As well, I reinvest the dividend automatically to purchase more shares. I have approximately 2,600 shares and they form the largest single portion of my RRSP portfolio. I was wondering what your advice would be on whether to buy, sell, or hold. ? D.D.

A ? We have looked at TimberWest Forest Corp. (TSX: TWF.UN) on occasion but it has never impressed us strongly enough to add it to our Recommended List. It?s not that there is anything inherently wrong with it, but we feel that the yield is rather thin at 7.5% and we are not impressed with the financials.

TimberWest is in the logging business on Canada?s West Coast. It is an efficient operation with low capital equipment costs. However, recent financial results have been disappointing, a fact acknowledged by CEO Paul McElligott earlier this month when second-quarter figures were released. They showed that distributable income for the first six months of 2005 came in at 51c per unit, down from 93c last year. That?s less than the trust is currently paying out.

?We are experiencing very soft domestic markets, and while demand for export logs has been good, currency and a weaker species mix have caused lower sales realizations in those markets,? the CEO said.

Dominion Bond Rating Service (DBRS) gives TimberWest a stability rating of STA-3 (low) which is actually quite good for a commodity-based trust. But the analysis notes that one of the major problems facing the trust is the high loonie. For every 1c rise in the Canadian dollar, profitability is reduced by an estimated $3.6 million.

Overall, the picture does not fill us with confidence. We can?t tell you what to do with the units your own ? that?s your call. But we will not be adding TimberWest to the IWB Recommended List any time soon. ? G.P.

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MEMBERS? CORNER

Avian flu

Member comment: Thanks for the update on this and for your original response to my question a few weeks ago. I’m pleased to see you are giving it some serious attention with real suggestions, while still holding a kind of ‘life goes on for now’ kind of reality check. ? I.K., Kingston ON

Response: Avian flu is certainly a concern. But we have to remember that we have had many scary warnings in recent years. For a time, there were legitimate fears that SARS would become a pandemic but thanks to the courageous efforts of our health care workers we managed to contain it. If we reacted to every threat, we?d keep all our wealth in gold coins in the cellar and never venture out the front door. At this stage, prudent awareness seems to be the right balance to maintain in the face of the threat. ? G.P.

Member comment: I really don?t think it is ?if? but rather ?when?. Those of us in the medical business have been discussing this for some time. We are ?overdue?.

We have actually made tentative plans as to how our clinic of six MDs would operate. For instance, assuming a one in three chance of becoming ill, that means that two of the six MDs (and support staff) will be incapacitated.

One stock that will do well in such a crisis: Roche Holdings. Check out http://www.tamiflu.com/

This is the only drug that might help prevent you from actually getting the flu or at least minimize the damage if you do get it. There will be a mass rush to buy it and a shortage is guaranteed. You might consider having a stockpile for yourself and your family. Consider it a form of ?insurance?. I have given my neighbors (and any patient who asks) the same advice. ? Dr. Rick

Response: Buying Roche shares seems like a natural in this situation but there are two problems. The first is acquiring any. Roche is a closely-held company, based in Switzerland. The Bank of New York has issued depository receipts (ADRs) on the non-voting shares for U.S. investors but they do not trade on any exchange in that country. The only way to acquire them is through the over-the-counter Pink Sheets (symbol RHHBY, closed Friday at US$69.15). Two of these ADRs are the equivalent of one non-voting Swiss share, according to a Roche spokesperson.

Many Canadian brokers (but not all) can acquire them if pressed, although they are generally reluctant to do Pink Sheets trades. Roche shares also trade in London and Zurich but as one broker put it: ?The commissions will eat you alive.?

The second concern is what will happen in the event the feared pandemic actually happens. There seems to be no concrete proof that Tamiflu will be effective against a mutated avian flu virus. If it is not, the share price will plunge. If it does work, in the event of a world-wide catastrophe the pressure on Roche to increase production and cut the price so Tamiflu can be more widely distributed will be enormous. That would not help the company?s bottom line. And once the pandemic has run its course, then what?

Roche is a good company with a large portfolio of quality products. But the price has already risen about US$20 a share this year, fuelled at least in part by growing avian flu fears. So think it through before you make the decision to add the shares to your portfolio. ? G.P.

Member question: Why do you not mention money market funds as a potential “safer” bet in your “Doomsday” piece? ? D.S.

Response: The list was not meant to be exhaustive but illustrative. In a severe economic downturn, cash is king. Money funds are the equivalent of cash (as are Canada Savings Bonds and cashable GICs). Since inflation is unlikely in the Depression-type environment a pandemic might create, cash is certainly an asset worth holding. ? G.P.

That?s it for this week. We?ll see you again on Tuesday Sept. 6. Have a fun and safe Labour Day weekend.

Gordon Pape

In This Issue

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THE OIL PRICE WILL RISE.. AND FALL

Oil prices touched another record last week as traders fretted about Hurricane Katrina and its potential disruption of supplies from the Gulf of Mexico. Meantime, a prominent economist, Jeff Rubin of CIBC World Markets, jumped in with a prediction of US$100 a barrel oil in our future.

No wonder investors are antsy and wondering what to do. Last week I received yet another e-mail from a member asking for my take on where oil and gas prices will go from here.

Well, I?m no economist (the best I can claim is an A in Economics 101 in college). But in one sense, the answer is a no-brainer ? prices will go up! The basic laws of economics make that a certainty. Demand is increasing, supply is diminishing. There is no other logical conclusion, at least over the longer term.

The short term is another matter, however. We?ve seen how oil prices can turn on a dime based on the latest news. A new tropical storm threat in the Gulf of Mexico? Prices rise. Higher than expected inventories? Prices fall. New tensions with Venezuela? Prices rise. OPEC to pump more oil? Prices fall. No one in their right mind would try to predict where oil prices will be one month from now, given all these variables.

What is clear is that high oil prices will inevitably have an impact on businesses and on consumers. Already many companies, including giants like Wal-Mart, are complaining of profit margins being eroded by rising energy costs. The high price of gasoline and home heating fuels will squeeze family budgets and force spending cuts elsewhere. The ripple effect will result in increases in everything from electricity bills to bus fares.

The short-term result will be falling demand. People will curtail the use of the family car and more will turn to public transit. Money that might have gone to a new chair for the living room or a winter coat will be diverted to pay the higher natural gas bill. Consumer spending will slacken, leading to production cut-backs. That in turn will reduce energy demand.

As the cycle takes hold prices will drop, assuming supply remains constant, and the market valuation of energy stocks will follow. As oil pulls back to the US$50 range or below we?ll see relief at the gas pumps, where the latest news bulletins seem to have an immediate effect. As the prices decline further, demand will begin to pick up again and the cycle will start all over.

So where are oil and gas prices going? Up, then down, then up again is my best guess. This has always been a volatile sector. There?s no reason to believe that anything has changed.

What should you do as an investor? It depends on your time horizon. If you are an active trader, you should continue to take some profits as prices move higher. Don?t sit on all your gains, especially if energy has become overweighted in your portfolio. There is no way of knowing where the top of this particular cycle is going to be.

Longer-term investors may prefer to live with the ups and downs, knowing that over time all good-quality energy stocks will increase in value. This is an especially useful strategy with companies or trusts that have long-life reserves and that provide decent cash flow in the form of dividends or distributions.

The time will come when the wells will run dry, of course. But it won?t happen for many years, probably not within our lifetimes, because the higher the oil price, the more economic it becomes to tap into unconventional sources. Remember, it wasn?t that long ago that people said the Alberta oil sands would never be economical!

So decide on which strategy you want to pursue and stick with it. You?re almost certain to make money. ? G.P.

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TOM SLEE SAYS TO BOARD THE TRAINS

Contributing editor Tom Slee is with us this week with a look at an industry that is very much in the news these days ? Canada?s railroads. Here are his comments.

Tom Slee writes:

Twenty years ago railways were a sunset industry. People thought of trains as museum pieces, dinosaurs. Trucks, the wave of the future, dominated the haulage business and pipelines were going to move the bulk commodities across the continent. It was time to put the iron horse out to pasture. No use fighting progress, right? Wrong! These days a lot of those trucks are stranded on our clogged highways. The vaunted pipeline feeder system has never materialized. Railways, meanwhile, are booming. In fact, I suppose you could call them a sunrise industry.

In fairness, some analysts see the railway renaissance as a short-lived phenomenon. They think that this is still an old-fashioned cyclical industry where a few companies, such as CN Rail, have done well. According to them, investors should take their profits and run. Others, me included, disagree. We believe that there has been a fundamental change in the North American transportation world, a basic shift to rail that offers substantial investment opportunities.

As far as Canadians are concerned, the game changed in 1995 when the government privatized CN Rail and unleashed a sleeping giant. Six years later, Canadian Pacific spun off Canadian Pacific Railway and gave us some real competition and a choice of stocks. However, as this is a continental industry the tracks don?t stop at the border and for the real sea change we have to go back to 1980, to the Staggers Rail Act in the U.S. That legislation, modeled on the Airline Deregulation Act, replaced a regulatory structure which had been in place since 1887 and almost bankrupted many railroads. It was like a breath of fresh air. All of a sudden, American railways could decide when and where to operate their trains and how much to charge.

Of course, it hasn?t all been smooth sailing since then. There have been several false starts but the cost cutting, equipment upgrades, and consolidations are finally paying off. In fact, several Wall Street observers regard 2004 as the year the U.S. railroads came into their own. The railways moved more freight than any other year in history, intermodal (container) volume topped 10 million trailers for the first time, and the leading companies purchased or leased 1,121 new locomotives, a 90% increase over 2003. As a matter of fact, in some regions companies were unable to handle the demand, a new experience for them, and there was congestion on lines running into Pacific coast ports in both Canada and the States. Union Pacific, for example, was caught short of equipment and crews.

Perhaps even more encouraging, the good times have rolled into 2005 and everything points to this being solid, sustainable growth. The flood of freight to and from China may subside but companies are already planning for the lift-off in trade with India. The American Association of State Highway and Transportation Officials (AASHTO) predicts that North American domestic freight will double and international freight will double or triple over the next 20 years. I guess you could call that a rising tide and it comes at a time when the trucking companies are struggling. Railways are stepping into the breach.

All of this means that the railroads are finally able to impose rate increases and these, unlike higher volumes that involve more costs, go straight to the bottom line. As a result, six of the seven major North American railroads beat analysts? earnings expectations in the second quarter. I find this particularly encouraging. For years we have watched these companies desperately slashing expenses in order to create some nominal earnings growth, with CN Rail the only outstanding performer. Now we have improved profit across the board.

In effect, U.S. economic growth skated the railways on-side. The original networks, laid in the 19th century, had enormous spare capacity that was never utilized because an aggressive trucking industry siphoned off the freight and people chose to travel by air. The railways languished and had little incentive to upgrade or expand their facilities. Transportation needs, however, continued to increase and now, almost overnight, it seems the entire system is under stress. All the slack has been used up.

According to a recent AASHTO study, our highways, already bottle-necked and overloaded, are unable to meet the projected demand. That, along with soaring fuel costs, is going to take the starch out of the trucking companies.

Railways too are bumping up against capacity. The West Coast system is seriously congested. In this case, though, the pressure works to the railroads? advantage. They have raised their rates and imposed surcharges to offset energy prices. Railways also have some room to increase efficiency. Trains are becoming longer and heavier. Locomotives already pull three times the load of their predecessors in the 1950s. Rearrangements of tracks and re-routing will provide more room. Most important, railways can selectively increase their rail networks and, in doing so, fatten their bottom lines.

It means that the leading railroads have evolved into a growth industry. With our transportation system stretched and demand increasing at an expected GNP growth rate of about 3%, carriers can increase rates, continue to shed their still excessive overhead, and extend their tracks. Of course, there are going to be peaks and valleys. Cyclical commodities still account for a large part of the volume. Despite this, earnings, especially for the better-managed railroads, should trend higher.

The railways have another plus. The boom times are unfolding just as their cut-throat competitors have lost their edge. For years analysts believed that in order to survive the railroads would have to recapture markets from the trucking companies. That is no longer the case. The hauliers are struggling with mounting costs as well as a shortage of drivers and, of course, they are unable to build new highways. As a result, most of the new and some of the existing business is shifting to the railways. Ironically, the trucking industry has become one of intermodal rail?s biggest customers. Strange times indeed!

So what does it all mean for small Canadian investors? Well, I think that several of the railway stocks look particularly attractive right now. For instance, Burlington Northern Santa Fe (NYSE: BNI) is currently trading at US$54.30, about 12 times next year?s expected earnings of US$4.40 a share. It?s relatively cheap. With freight revenues growing at 15% and a 78% operating ratio (the proportion of revenue consumed by expenses) the company is on a roll and we could see the stock at US$65 or more next year.

This is a good choice for investors looking for a U.S. transportation stock for their portfolios and I am adding it to my Buy list.

My first choice, however, is Canadian Pacific Railway with CN Railway a close second. It?s not because they are Canadian, but because they have the most upside potential. See my updates for the reasons why.

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UPDATES

CANADIAN PACIFIC RAILWAY (TSX, NYSE: CP)

Originally recommended on Feb. 26/01 (IWB #2108) at $26.45. Closed Friday at $45.90 (US$38.34).

Canadian Pacific Railway turned in an excellent second quarter and then some. Profit jumped 47% year-over-year from $83.7 million or 53c a share in 2004 to $123.2 million, or 77c. Operating results, stripped of all non-recurring items, were up 34% to 87c a share. CEO Bob Ritchie said that ?it had been a long, hard slog but now there is some sunshine?.

He had good reason to be happy. Revenues grew in five of CPR?s seven divisions during the second quarter. Coal jumped an astonishing 48%. The lucrative intermodal business was up 19%. Meanwhile, operating expenses were contained despite a 35% year-over-year increase in fuel costs. As a result, the company?s all-important operating ratio fell 2.5% to 75.5%. To put that into perspective, CSX Corporation, the largest rail network in the Eastern United States, has an 83% operating ratio.

There was more good news. The company announced the renewal of a major long-term contract with the potash producers and this takes care of the coal and potash shipments that CPR needs to utilize its expanded western corridor. Management has already signed a five-year deal with Elk Valley Coal, the world?s largest producer of metallurgical coal.

Looking ahead, the company expects to make about $3.20 a share this year but I think that it will do better. We could see $3.30. The real opportunities, though, are in 2006. The outlook for grain is encouraging, the company will participate in increased potash prices, and its network expansion should start paying off. Earnings could exceed $4 a share.

Action now: Buy Canadian Pacific Railway at $45.90 with an increased target of $55. I have set a revisit level of $42.


CN RAIL (TSX: CNR, NYSE: CNI)

Originally recommended on May 6/02 (IWB #2218) at $51.90. Closed Friday at $80.07 (US$66.85).

At CN Railway, the second-quarter numbers were also impressive, the sort of results we have come to expect from North America?s most efficient railway. Profit for the three months ended June 30 increased to $416 million ($1.47 a share), up 30% from $362 million ($1.13 a share) in 2004. Analysts had been looking for $1.34.

Here again, as with all the railways, it?s good to see solid top-line growth. Revenues were up 10%, almost 15% if you exclude foreign exchange adjustments. Cash flow from operations was $730 million, triggering an announcement that the company is going to buy back 16 million of its common shares. Costs rose a miniscule 3% as lower labour expenses offset rising oil prices and CN?s operating ratio fell to a record 61.2%, the best in the industry. To quote one leading analyst: ?Wow!?

But a word of caution. CN Rail was involved in five accidents during August including the serious spill at Wabamun, Alta. The unions have complained that these incidents resulted from cost cutting and skimping on maintenance. In other words, they claim the record operating ratio comes with a price. In fact, the company has an excellent safety history and its accidents per million train miles fell from 2.44 in 2001 to 1.71 last year. Nevertheless, it’s something I’m going to watch very closely.

The question is ? where does this lean machine go from here? The answer, I think, is onward and upward, albeit at a slightly slower rate. There is little room for more cost cutting but revenues should continue to grow as a result of demand and rate increases. The ace is CN?s acquisition program. Its recent purchases of Great Lakes Transportation and BC Rail were a neat fit. Most railway mergers involve a lot of overlap and duplication. Great Lakes and BC Rail added length to the system and the deals should add 35c to earnings this year and 45c in 2006.

CN remains by far the best railway. The only reason CPR is my first choice at the moment is because it has more room to improve.

: Buy CN Railway at $80.07 with an increased target of $94. I will revisit the stock if it dips to $72.


HOME DEPOT (NYSE: HD)

Originally recommended on April 26/05 (IWB #2516) at $36.02. Closed Friday at $39.81 (All figures in U.S. dollars.)

Elsewhere, Home Depot beat nearly everybody?s estimates by posting a 14% jump in second-quarter profits. Thanks to additional product lines, expanded self-checkout services, and better inventory controls, the company earned $1.77 billion, equal to 82c a share, compared to $1.55 billion (70c a share) a year earlier.

HD continues to focus on improving same-store sales and opening new outlets on a very selective basis. This is a far cry from the old expansion at any cost policy. At the same time, Depot remains on the acquisition trail. Last month it purchased National Waterworks, a contractor supply business, for $1.35 billion. It?s a major step into the professional contractor space; a move to cushion economic cycles.

The fundamentals are in good shape at Home Depot and the company should make $2.60 a share this year, up 15% from $2.26 in 2004. The bad news is that the stock has been buffeted by concerns about Wal-Mart and some poor U.S. housing numbers. I see the present weakness as a buying opportunity.

Action now: Buy Home Depot at $39.81 with a target of $48. I have set a $35 revisit level.


BOMBARDIER SERIES 4 PREFERREDS (TSX: BBD.PR.C)

Originally recommended on March 8/04 (IWB #2410) at $25.01. Closed Friday at $20.65

Bombardier is again in the news, with announcements that 20 of its plane orders from Delta Air Lines are no longer endangered and Austrian Railways has ordered 60 rail vehicles worth US$223 million. The slow recovery continues. In fact, the long-term outlook is actually improving. The company should make about 18c a share next year, its aerospace backlog has inched up to $10.4 billion, and the restructuring plan is on track.

All of this means that the preferred dividends are safe for now, although a lot could go wrong, and remain attractive for investors able to assume some risk who are seeking above average income.

Action now: Buy the Bombardier Series 4 Preferreds at $20.65 to yield 7.5%, equivalent to 9.6% from a bond after adjustment for the dividend tax credit.

– end Tom Slee

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THE BAY?S NEW REWARD ? READ THE FINE PRINT!

An intriguing press release came through my e-mail box last week. Just in time for the Back to School season, it proudly announced that participants in The Bay?s rewards program will now be able to exchange 100,000 points for a $100 contribution to a new registered education savings plan (RESP) opened through Canadian Scholarship Trust Plan (CST) or Heritage Education Funds.

The initiative ?raises the bar on customer rewards programs?, the release proclaims. The Bay?s CEO, George Heller, is quoted as saying his company is ?proud to be able to give all Hbc Rewards members the opportunity to start an RESP today.?

It all sounds very noble. But before you rush to set up a plan, take a close look at the prospectuses. CST?s, for example, runs to a mind-boggling 80 pages. In order to get that $100 from Hbc Rewards, you have to commit yourself to paying what could add up to a lot of money.

For example, if you decide to open a CST Group RESP (for children up to age 12) that will cover all your family members, there?s an enrolment fee of $200 a unit. The more you want to contribute, the more units you have to purchase. There are some complicated tables and examples included in the prospectus that will take some work to figure out. There are also some annual fees on top of this.

When you start contributing to the plan, all the money you put in (yes, all) is applied against your enrolment fee until half the amount due is paid. That means you are not putting any money aside for your youngster in the early stages ? you are simply paying fees. Once half the amount owed has been paid off, 50% of your contribution goes towards the fees until they are discharged, with the other half to savings. The CST prospectus gives this example:

?If you are contributing $50 per month and the total enrolment fee is $500, the enrolment fee would be paid as follows:

?? first five months: $50 per month would go to the enrolment fee (this equals $250, which is one-half of the enrolment fee).

?? subsequent 10 months: $25 per month would go to the enrolment fee (this equals $250, which fully pays the enrolment fee) and $25 per month would go to the Principal.

?? subsequently $50 per month would go to the Principal.?

So after 15 months you would have paid out $750 of which $500 would have gone to fees and $250 to your child?s account. You will get your enrolment fees back down the road, if you make all the required contributions and if your child receives all four education grants from the trust.

It?s also important to understand what happens if you decide not to continue with the program. If you cancel after 60 days, you will lose all the enrolment fees you have paid as well as any interest earned. You will get your principal back, once the costs have been deducted.

The Family and Individual plans for children 13 or older have different rules and much lower fees. The minimum initial contribution is $150.

The terms and conditions for Heritage Funds may differ somewhat. See their website.

Scholarship trusts have provided financial assistance to a lot of students over the years. But opening an RESP with one of them involves a significant financial commitment for a family. So don?t rush into it just because you can get $100 from Hbc Rewards. There?s a lot to consider. Do your homework. ? G.P.

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INCOME TRUST SCORECARD

RBC Capital Markets reports that more than 72% of income trusts met or bettered their forecast results in the second quarter. The figures were based on cash flow from operations (CFFO). Trusts that were within 5% of forecast on either side were considered to have met expectations. Those that exceeded or fell short of the 5% window were classified as ?Better than forecast? or ?Below forecast?.

Exactly half the 84 reporting trusts met their forecast, with 22.6% coming in higher and 27.4% underachieving. RBC noted that there was no clear pattern to the weak performers but all five restaurant trusts did better than predicted. ? G.P.

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UPDATES


CANADIAN UTILITIES (TSX: CU.NV)

Originally recommended by Gordon Pape on May 1/00 (IWB #2017) at $18.88 (split adjusted). Closed Friday at $36.39.

Investors received a pleasant surprise on July 28 when Canadian Utilities announced a two-for-one stock split, effective Sept. 15. The shares started trading on a split-adjusted basis on Thursday, Aug. 25. The split is being done in the form of a stock dividend, with one extra share for each one you currently own. All shareholders of record as of Aug. 29 will benefit.

Three days earlier, the company released second-quarter results. They showed operating earnings of $50 million (79c a share), up from $45.1 million (71c a share) for the same period last year.

The stock?s September dividend of 55c a share will be paid on a pre-split basis. Future dividends will be half that amount, unless an increase is announced.

This company has done very well for us over the past five years and I continue to regard it as a core position.

Action now: Hold. ? G.P.


LOBLAW COMPANIES (TSX: L)

Originally recommended by Gordon Pape on June 17/02 (IWB #2223) at $58.60. Closed Friday at $69.50.

Second-quarter results from Loblaw continue to show progress despite on-going restructuring costs which nibbled away at the bottom line. The big grocery retailer said net earnings for the period to June 30 were $211 million (76c a share, fully diluted) compared to $197 million (71c a share) during the same period in 2004. Management reported that 2c had been knocked off the earnings per share figure by expenses relating to an extensive restructuring program which it is estimated will cost $90 million by the time it is completed in 2007. Of that, $70 million will be recognized in expenses this year. Sales for the quarter were up 6% although same-store sales were disappointingly flat.

The stock pays a quarterly dividend of 21c a share, with the next payment due on Oct. 1.

Action now: Loblaw remains a Buy. ? G.P.

RIOCAN REIT (TSX: REI.UN)

Originally recommended by Gordon Pape on April 20/98 (IWB #9814) at $10.90. Closed Friday at $21.50.

RioCan?s second-quarter results continued to show why this is Canada?s blue-ribbon REIT. Recurring distributable income (RDI) came in at a record $140.3 million (72.7c a unit), up 15% from $121.8 million (67.8c a unit) for the comparable period in 2004. However, both net earnings and funds from operations (FFO) were down because of the redemption of some of the trust?s unsecured debentures at a cost of slightly more than $20 million. This was fully expensed in the first half of the fiscal year.

At the same time, the trust announced it is increasing the monthly distribution to 10.75c a unit ($1.29 a year), up from 10.5c previously. For long-time members who bought RioCan shares when I first recommended them back in 1998, this means your yield will now rise to 11.8%. This is exactly how a top-quality REIT should perform ? stick it in your portfolio and watch the cash flow and the market value rise over time.

Action now: Hold. ? G.P.

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YOUR QUESTIONS

What about TimberWest?

Q – I was an employee of TimberWest for 13 years and then was severed in 2002 along with 50 other employees. During my employment, I had purchased shares and trust units through payroll deduction and rolled those directly into an RRSP. As well, I reinvest the dividend automatically to purchase more shares. I have approximately 2,600 shares and they form the largest single portion of my RRSP portfolio. I was wondering what your advice would be on whether to buy, sell, or hold. ? D.D.

A ? We have looked at TimberWest Forest Corp. (TSX: TWF.UN) on occasion but it has never impressed us strongly enough to add it to our Recommended List. It?s not that there is anything inherently wrong with it, but we feel that the yield is rather thin at 7.5% and we are not impressed with the financials.

TimberWest is in the logging business on Canada?s West Coast. It is an efficient operation with low capital equipment costs. However, recent financial results have been disappointing, a fact acknowledged by CEO Paul McElligott earlier this month when second-quarter figures were released. They showed that distributable income for the first six months of 2005 came in at 51c per unit, down from 93c last year. That?s less than the trust is currently paying out.

?We are experiencing very soft domestic markets, and while demand for export logs has been good, currency and a weaker species mix have caused lower sales realizations in those markets,? the CEO said.

Dominion Bond Rating Service (DBRS) gives TimberWest a stability rating of STA-3 (low) which is actually quite good for a commodity-based trust. But the analysis notes that one of the major problems facing the trust is the high loonie. For every 1c rise in the Canadian dollar, profitability is reduced by an estimated $3.6 million.

Overall, the picture does not fill us with confidence. We can?t tell you what to do with the units your own ? that?s your call. But we will not be adding TimberWest to the IWB Recommended List any time soon. ? G.P.

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MEMBERS? CORNER

Avian flu

Member comment: Thanks for the update on this and for your original response to my question a few weeks ago. I’m pleased to see you are giving it some serious attention with real suggestions, while still holding a kind of ‘life goes on for now’ kind of reality check. ? I.K., Kingston ON

Response: Avian flu is certainly a concern. But we have to remember that we have had many scary warnings in recent years. For a time, there were legitimate fears that SARS would become a pandemic but thanks to the courageous efforts of our health care workers we managed to contain it. If we reacted to every threat, we?d keep all our wealth in gold coins in the cellar and never venture out the front door. At this stage, prudent awareness seems to be the right balance to maintain in the face of the threat. ? G.P.

Member comment: I really don?t think it is ?if? but rather ?when?. Those of us in the medical business have been discussing this for some time. We are ?overdue?.

We have actually made tentative plans as to how our clinic of six MDs would operate. For instance, assuming a one in three chance of becoming ill, that means that two of the six MDs (and support staff) will be incapacitated.

One stock that will do well in such a crisis: Roche Holdings. Check out http://www.tamiflu.com/

This is the only drug that might help prevent you from actually getting the flu or at least minimize the damage if you do get it. There will be a mass rush to buy it and a shortage is guaranteed. You might consider having a stockpile for yourself and your family. Consider it a form of ?insurance?. I have given my neighbors (and any patient who asks) the same advice. ? Dr. Rick

Response: Buying Roche shares seems like a natural in this situation but there are two problems. The first is acquiring any. Roche is a closely-held company, based in Switzerland. The Bank of New York has issued depository receipts (ADRs) on the non-voting shares for U.S. investors but they do not trade on any exchange in that country. The only way to acquire them is through the over-the-counter Pink Sheets (symbol RHHBY, closed Friday at US$69.15). Two of these ADRs are the equivalent of one non-voting Swiss share, according to a Roche spokesperson.

Many Canadian brokers (but not all) can acquire them if pressed, although they are generally reluctant to do Pink Sheets trades. Roche shares also trade in London and Zurich but as one broker put it: ?The commissions will eat you alive.?

The second concern is what will happen in the event the feared pandemic actually happens. There seems to be no concrete proof that Tamiflu will be effective against a mutated avian flu virus. If it is not, the share price will plunge. If it does work, in the event of a world-wide catastrophe the pressure on Roche to increase production and cut the price so Tamiflu can be more widely distributed will be enormous. That would not help the company?s bottom line. And once the pandemic has run its course, then what?

Roche is a good company with a large portfolio of quality products. But the price has already risen about US$20 a share this year, fuelled at least in part by growing avian flu fears. So think it through before you make the decision to add the shares to your portfolio. ? G.P.

Member question: Why do you not mention money market funds as a potential “safer” bet in your “Doomsday” piece? ? D.S.

Response: The list was not meant to be exhaustive but illustrative. In a severe economic downturn, cash is king. Money funds are the equivalent of cash (as are Canada Savings Bonds and cashable GICs). Since inflation is unlikely in the Depression-type environment a pandemic might create, cash is certainly an asset worth holding. ? G.P.

That?s it for this week. We?ll see you again on Tuesday Sept. 6. Have a fun and safe Labour Day weekend.

Gordon Pape