In this issue:

CANADIAN OIL SANDS STILL LOOKS GOOD

By Gavin Graham, Contributing Editor

The first column that I wrote for The Income Investor five years ago recommended buying units of Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF). At the time, I commented that although it didn’t have the highest yield in the energy sector, the trust had the potential to increase its payout over time. That would lead to an increase in cash flow as well as an upward move in the share price as other investors were attracted to the increasing profits and distributions generated by the company.

I am pleased to say that, in this case at least, the theory proved correct. I recommended COS at $16.85 in March 2005. At the time the units paid a quarterly distribution of 10c, or 40c per unit annualized. Although there have been ups and downs along the way, the current distribution has more than tripled to 35c a unit, while the share price has almost doubled to $30.93 (price as of April 23). This compares favourably with both the broader stock market, where the S&P/TSX Composite Index has risen by less than 35% since March 2005, and with the Energy Trust Index, which has actually fallen over the same period.

Of course, there has been volatility along the way. Less than two years ago, with oil nudging US$148 per barrel, Canadian Oil Sands was trading over $50 and distributing $1.25 per quarter. Nonetheless, it has proved to be a very rewarding investment for those who stayed the course. Let’s examine some the reasons why this proved to be the case and what the outlook is for the next five years.

Why we liked it: The reason that the managers at Guardian Capital’s income funds have owned Canadian Oil Sands for the last dozen years is very simple. As long as the price of oil remained above US$25 per barrel, the trust, as the owner of the largest stake (36.74%) in the Syncrude oil sands consortium, would be profitable. It was the original oil sands development with its infrastructure already in place and did not face the same cost pressures as the new projects that were being built to take advantage of the higher oil prices in the past decade.

The other reason for liking the trust was that it was expanding production. The Stage 3 expansion increased Syncrude’s output (and Canadian Oil Sands’ share) by one-third to 350,000 barrels a day. Thus, even if the price of oil did not increase, Canadian Oil Sands’ revenues and profits would rise. Once the capital expenditure on the expansion was finished, the trust would have more cash available to distribute to its investors.

Furthermore, to reduce the risk of its expensive Stage 3 expansion, Canadian Oil Sands had hedged the oil price it received by selling its production in the forward market. The trust also hedged its U.S. currency exposure to ensure that it received enough cash to pay for the expansion, whatever happened to the oil price and currencies. As the oil price and the Canadian dollar were both appreciating while Stage 3 was being built, the trust surrendered potential profits for a guarantee that it would have enough cash. Once the expansion was completed, although (as with virtually every other oil sands project) it was both late and over budget, these hedges were allowed to expire.

Thus investors in Canadian Oil Sands between 2005 and 2008 received a triple bonus. First, Syncrude’s oil production increased by one third; second, the price of oil more than doubled; and last, the oil and currency hedges that Canadian Oil Sands had sensibly put in place expired.

Add to this the fact that the price of gas, which Syncrude uses to boil up the thick molasses-like bitumen that comprises the oil sands, actually fell by half during this period. Gas prices had spiked to nearly US$15 per million cubic feet (mcf) in the aftermath of Hurricane Katrina in October 2005. But the price fell rapidly after that as new supplies of shale gas and imports of liquefied natural gas (LNG) emerged to replace lost supplies.

When all this is added together, it is easy to see how distributions rose more than 12 times from 10c to $1.25 per quarter while the share price more than tripled.

Risk factors: As with any resource-based investment, the value of the underlying commodity is the most important factor influencing share price movement. When the price of oil collapsed during the recession, falling from US$148 per barrel in June 2008 to US$38 in February last year, so did Canadian Oil Sands’ profits and distributions. The total annual distribution rose steadily from 40c per unit in 2005, through $1.10 in 2006, $1.65 in 2007, and culminated in a high of $3.75 in 2008. But when oil prices plunged, the distribution was cut sharply to 90c last year as earnings fell from $1.4 billion in 2008 to $433 million in 2009.

On another front, environmental protestors were stirred to action when several hundred migrating ducks were trapped in the oily residues of Syncrude’s tailings ponds. Also, concerns were expressed that the process of strip mining which extracts the oil sands for processing at Syncrude’s Fort McMurray plant was a major generator of carbon emissions and would be adversely affected by new U.S. legislation penalizing oil produced by “dirty” (i.e. high CO2 emitting) sources.

From a financial perspective, the new Alberta royalty regime introduced by Premier Ed Stelmach in 2009 was perceived as a negative, even though Syncrude was exempted from the legislation as it was organized under a different royalty system. Also, investors worried about plans to build an expensive new bitumen upgrader to transform the lower grade product of Syncrude into higher value synthetic light oil.

Yet there were signs that perhaps the pessimism was overdone. In August 2009, Chinese state-controlled oil giant PetroChina paid $1.9 billion for a 60% stake in Athabasca Oil Sands, which, while it had extensive oil sands acreage near Fort McMurray, had no production and would need to spend several billion dollars to start operations by 2015. Applying the same valuation per barrel of oil equivalent (boe) to Canadian Oil Sands implied a substantial premium above the existing share price.

Then in October, 2009, ConocoPhillips, the third-largest U.S. oil major, indicated it was looking at selling its 9% stake in Syncrude to help raise US$10 billion to reduce the debt burden taken on in its ill-timed acquisition of gas producer Burlington Resources in 2006. Some investors were concerned that Canadian Oil Sands, the logical buyer of the stake, would have to issue shares to fund the purchase, which was estimated to cost $3.65 billion, although brokers’ analysts estimated that such a purchase would not be dilutive as long as Canadian Oil Sands didn’t pay more than $4.1 billion.

Recent developments: Earlier this month, the buyer of Conoco’s stake was announced. It was not Canadian Oil Sands; instead another state-controlled Chinese oil company, Sinopec, bought the stake. The price was US$4.65 billion, showing that rising oil prices as the world economy revives have helped to increase the value of Canadian Oil Sands’ assets.

As commodities guru Don Coxe at Nesbitt Burns pointed out, what this also demonstrated was that the emerging economies of China, India, and Brazil, with growing middle classes driving their ravenous appetite for raw materials, are willing to pay high prices for secure, long-life natural resource assets in politically stable countries like Canada and Australia. Analysts doing the math, such as Randy Ollenberger at BMO Nesbitt Burns, announced that Canadian Oil Sands, using the same valuation as Sinopec paid, was worth $37 per share. He also pointed out that the price of Canadian Oil Sands had been depressed due to fears of an equity issue to pay for the Conoco stake, and that they should now be re-evaluated.

Siren Fisecki, the spokesperson for Canadian Oil Sands, announced in February that, while Syncrude still planned to increase its output by 2020, it would now look to raise its daily output to 540,000 barrels per day instead of 500,000 from its present 350,000 by not building the expensive upgrader. This would result in “substantial savings”, he said. “We’ve always talked about expanding. It’s just how we will expand (that) has evolved and changed.”

Instead, Syncrude will raise bitumen production by 115,000 barrels a day and add another 75,000 barrels by streamlining its existing plant. Apart from the high cost, one of the reasons given by analysts for this move is that the traditional 20%-30% discount that “heavy” oil such as that produced from bitumen sold in the U.S. has narrowed to 10%, thus removing the profit margin for upgraders. This was due to a sharp decline in exports of heavy oil from traditional U.S. suppliers such as Mexico, as the massive Cantarell field in the Gulf of Mexico has seen output more than halve in the last five years. There has also been a decline in shipments from Venezuela, which like Canada produces heavy oil from bitumen. So U.S. refineries have turned to Canada to fill the gap.

Finally, Canadian Oil Sands has announced that it will transform itself into a corporation once the change in trust taxation takes place on Jan. 2, 2011 as there will no longer be any benefit to remaining a trust. There will be no change in its quarterly distribution policy, which has always varied widely dependent upon the price of oil and the U.S. dollar exchange rate.

Summing up: The recent Sinopec purchase of Conoco’s 9% stake and the value it implies, the cancellation of the upgrader by Syncrude, and the plans to expand production by 40% over the next decade have removed uncertainty and reinforced the attractiveness of the oil sands as a strategic asset. All this ensures that there will be growth in revenues and distributions regardless of what the oil price does. In other words, Canadian Oil Sands is in a very similar position to when we made our initial recommendation five years ago and should prove as rewarding for investors as the last five years have done.

Action now: Buy. Based on Friday’s closing price the units currently yield 4.53%.

Gavin Graham is one of Canada’s best-known financial commentators and Global Strategist for Excel Funds.

 

Return to the table of contents

DON’T SIT ON YOUR CASH

By Tom Slee, Contributing Editor

Despite growing concern that Greece may actually default on its sovereign debt, North American interest rates continue to drift sideways. In fact, they are not responding to any news, good or bad. The reason, I suspect, is that institutional investors are confused. Most economic indicators are encouraging but central banks keep giving mixed signals.

For instance, Federal Reserve Chairman Ben Bernanke has been reassuring people that interest rates are going to remain low until the recovery is well underway. That seems clear enough but a few weeks ago he suddenly raised the U.S. discount rate, which is the rate the Fed charges for emergency loans to banks, by 25 basis points (0.25 percentage points).

The Bank of Canada, torn between inflation and a strong loonie, has everybody guessing. Last week’s statement removed the Bank’s commitment to hold its key target rate at 0.25% until the end of June, prompting immediate speculation that we could see a quarter-point hike as early as the June 1 policy announcement. But then the March inflation numbers came in much lower than expected, causing some analysts to suggest the Bank may hold off for a while. In short, there is no clear direction.

Not that our bond markets have been quiet. On the contrary, underwriters are working overtime to feed a fierce demand for new issues. Money managers seem happy to gobble up any IPO or refinancing regardless of relatively unattractive returns and, in some cases, lower quality. Overseas investors are also willing to buy anything as long as it’s stamped Canadian.

So, as you would expect, the federal government, the provinces, and Canadian corporations have been busy raising capital. New corporate bonds were hitting the street at the rate of more than $2 billion a week during March as Royal Bank, Husky, and Manulife, amongst others, filled their coffers.

Normally all this activity would drive interest rates higher. For now, though, supply and demand remain balanced. There is no significant movement in the aftermarket.

Where does this leave small fixed-income investors? Well, I still think that U.S. and Canadian interest rates are going to inch up this year regardless of how the economies perform. The huge budget deficits will take a toll in the second half and we are bound to see a flood of government bonds to cover the shortfall. At the same time, foreign investors are likely to divert at least some of their buying to U.S. markets and take advantage of a resurgent greenback as the Federal Reserve gets its house in order. That will drive Canadian bond prices down and yields higher.

My suggestion, therefore, is that investors needing more income should start extending term. There is no point in sitting on cash earning 1.5% or less and waiting for a sudden surge in rates. With Mr. Bernanke’s foot on the brake, it’s going to be a gradual trend. Above all, shop carefully and stay with top-quality issues. Be patient, there are some good values out there.

For example, the Bell Aliant 4.95% debentures maturing in February 2014, with a BBB high rating, were recently trading at $105 to yield 3.46%. With less than a five-year term they are partially protected against any sudden slump in bond prices.

Bond ladders

I have the same advice for readers who are creating or updating their mid-term bond ladders. Maintain your program. Forget about market timing. To recap briefly, a ladder consists of a series of bonds, usually of equal weight, that mature in sequence. This arrangement provides you with an average yield, somewhere between the short and medium bond market returns. In addition, because a portion of the portfolio comes due each year or two, you always have cash available to take advantage of rising rates. Conversely, because the bulk of your money remains invested, you still earn an above-average total return even if any proceeds are reinvested at a lower rate.

For example, say you owned $100,000 worth of Canada bonds maturing in 2012 yielding 1.50%, $100,000 in Canadas of 2014 paying 2.5%, and a further $100,000 in bonds due in 2016 and yielding 3%. In this case, your overall yield is 2.33% and the average term is four years. Yet you have money coming due in two years. When that happens, you can reinvest the proceeds in the Canadas of 2018 and maintain your average four-year term. If returns have plunged and the new bonds earn only 1% your overall yield is still a better-than-average 2.07%.

This is a popular fixed-income technique but recently some readers, presumably still hunkered down because of the crisis, have been asking whether they should resume “ladder” investing. The answer is yes, absolutely. I think that long-term income-seeking investors should always have a bond ladder in place, although it’s tough to maintain when we are in a crisis and safety becomes an overriding factor. The important thing is to stay with the process. Market timing defeats the purpose. You usually end up heavily in cash waiting for rates to change, always a dangerous fixed-income strategy.

Buying and selling bonds

Readers have also asked about the mechanics of buying and selling bonds at what is known as the retail level. Here’s the story but keep in mind that this is a sprawling, unregulated market with no hard and fast prices.

Let us assume that an advisor has recommended the Telus Corporation 5.95% debentures due April 15, 2015, and you want to buy $20,000 worth of the issue. As there are no reliable published corporate bond prices, start by asking your broker for a quote. He will contact his trading desk to see whether there are any of these bonds in the firm’s inventory. If not, the trader can estimate a current market level although he is going to be reluctant to shop for a small amount of bonds without a firm order and a lot of latitude in the price. The firm is not going to run the risk of owning these bonds if you change your mind. So the best approach is to place a firm order with clear limits and if the broker is unable to provide a “fill” ask him to suggest some comparable alternatives with an A credit rating or better, although a BBB+ is sometimes acceptable.

On the sell side the process is reversed with your broker likely to offer a good price if his trader can dispose of your bonds quickly or is willing to keep them in inventory. Government of Canada bonds, for instance, are always liquid and easy to move. Obscure long-term corporate issues may have almost no market at all.

It’s all very unsatisfactory because there is no public auction market. Traders bid and offer amongst themselves. Prices vary depending on the size of order and sometimes how keen a buyer or seller is to complete a transaction. For instance, sinking funds have quotas of bonds to retire and sometimes pay outlandish amounts for relatively small parcels to complete their fill. In addition, because the firm you are dealing with is buying or selling for its own account, any commission forms part of the price. That places your broker in an odd sort of conflict of interest. He/she is supposed to provide you with good service and a competitive price while at the same time the firm is making a profit on the transaction.

I am not suggesting that the process is unethical or that the broker is trying to gouge you, although there are some sharp practices. It’s just that the bond market is an unregulated jungle. Institutions protect themselves by having full-time seasoned bond traders on staff.

My suggestion is that you should, if possible, shop around. Try and get several quotes. Then set firm price limits and remain patient. A good broker should be able to provide you with alternative offers. There are always plenty of comparable bonds available.

New bond issues

The new issue side of the market is booming these days. Here there are time constraints and you have to act quickly but the prices, at least initially, are firm and readily available. Moreover, the brokers’ fees have already been paid by the issuing company. New issues work like this:

A corporation wishing to raise capital retains an underwriter who “sounds” the market by unofficially consulting with major institutions and establishes whether there is a demand for the offering, how much investors can absorb, and on what terms. At this stage, the news of an impending deal usually becomes widespread and you can tell your broker that you may have an interest depending on the term, coupon, price, and resulting yield. By the way, most new issues are usually very popular because the underwriters price them below the market in order to spur demand. In fact, they are often “hot” and some sell out within an hour. Some are even over-subscribed and go to a premium.

The result is that small investors usually stand little chance of getting their orders filled at issue price. My suggestion, therefore, is that in addition to having your broker keep you up to date about any pending issues, make sure he/she tells you about the immediate aftermarket. You know the issue price and can tell if there has been much price movement. If the issue laid an egg and actually dropped in value, you could step in and get a bargain.

Preferred shares

With higher interest rates now an almost certainty, most preferred share prices have been slipping. This entire market has weakened. Let’s face it, preferreds served us well with safe above-average returns during the market collapse and record low interest rates. But straight preferreds, with their fixed dividends, trade like very long bonds and I would expect them to move even lower during the balance of this year.

Floating rate preferreds are another matter. Their dividends increase as interest rates rise and as a result they are now looking much more attractive. Investors have been buying them despite their relatively poor yields in order to earn a better return down the road. In some cases their prices have jumped due in part to the fact that top-quality floating rate preferreds are few and far between.

For comments the BCE floating rate preferreds that I have recommended in December, see the Updates section.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed-income securities.

 

Return to the table of contents

APRIL?S TOP PICKS

Here is our top pick for this month. Prices are as of the close of trading on Friday, April 23 unless otherwise specified.

Reitmans (Canada) Ltd. (TSX: RET.A, OTC: RTMAF)

Type: Common stock
Trading symbol: RET.A, RTMAF
Exchange: TSX, Grey Market
Current price: C$18.65, US$18.51 (April 21)
Entry level: Current price
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.reitmans.ca

The business: Reitmans operates 977 retail stores across Canada under its own name as well as other banners such as Smart Set, RW & CO., Penningtons, Addition-Elle, Thyme Maternity, and Cassis. All except RW & CO focus exclusively on women’s fashions.

The company traces its history back to the early 1900s when Herman and Sarah Reitman ran a small department store in Montreal. The Reitmans Company was founded after a second store was opened in 1926 and has grown steadily since to become one of the largest publicly-traded retail companies in Canada.

The security: We are recommending the common shares of Reitmans Ltd. which trade on the TSX under the symbol RET.A. These are non-voting shares and the company remains under the control of the Reitman family, with Jeremy H. Reitman the president.

Why we like it: For starters, the timing is right. Like many retailers, Reitmans was hard-hit by the recession. Earnings per share (EPS) for the 2010 fiscal year (ending Jan. 30) came in at 98c, down from $1.21 in fiscal 2009. Although the company reported a small 0.5% increase in revenue for the year, to $1.057 billion, same-store sales were down 1% and operating earnings fell 12.4%.

However, by the fourth quarter it was evident that a turnaround was taking place as the economy began to recover and people returned to the malls. Sales for the quarter were up 2.4% year-over-year and same-stores sales increased 1.5%. Net earnings for the quarter were up 56.9% with EPS coming in at 21c.

Everything points towards a continued rebound in the company’s business and the movement of the share price in recent months reflects that. The stock traded in a narrow range of $16 to $17 from October to late March when the year-end results came out. From there it spiked to the current level.

The second reason we like this stock, and the one of greatest significance to readers of this newsletter, is a healthy dividend of 72c a year. Based on a share price of $18.65 that represents a yield of 3.86%. I believe the dividend is safe and if business continues to improve we could see increases down the road.

Financial highlights: In an analysis published after the year-end results came out, RBC Capital Markets increased its projection for fiscal 2011 EPS to $1.27 from $1.22. For fiscal 2012, the brokerage firm predicts earnings of $1.47 per share, up from $1.40.

In the report, analyst Tal Woolley and associate Daniel Armstrong highlighted the company’s strong liquidity position which they say “bodes well for future shareholder value creation opportunities” such as acquisitions and buybacks. The company currently has a normal course issuer bid in place to buy back up to 2.7 million class A shares or 5% of the total. They estimated that the company should be in a position to deliver $100 million in free cash flow this year.

The balance sheet is in excellent shape. Reitmans reported cash holdings of almost $230 million at the end of the 2010 fiscal year and has long-term debt of only $11.4 million in the form of a mortgage on the company’s distribution centre. For all practical purposes, the firm is debt-free.

Risks: As we saw during the recently-completed fiscal year, Reitmans is vulnerable to economic downturns. A double-dip recession would slow the company’s growth and reduce the chances of a dividend increase or some other action to increase share value.

There is also some currency risk. Reitmans pays for much of its merchandise in U.S. dollars. When the loonie is strong, it works to the company’s advantage but when it drops sharply the result can be increased costs. Reitmans employs some currency hedges to mitigate this but reported that in fiscal 2010 fluctuating exchange rates had a negative impact of about $10 million on gross margin.

Distribution policy: Dividends of 18c a share are paid quarterly in January, April, July, and October.

Tax implications: Payments are eligible for the dividend tax credit if held by Canadians in non-registered accounts.

Who it’s for: The shares are suitable for investors who want to diversify their divided-paying stock portfolio with a top-quality retailer. We rate it as moderate risk although the shares would be vulnerable to a possibly significant pull-back in an economic downturn.

How to buy: The shares trade primarily on the Toronto Stock Exchange. Volume can be relatively light, sometimes less than 50,000 per day, but you should have no problem being filled. Reitmans also trades in the Grey Market in the U.S. as RTMAF but volume there is very low and some days there are no trades at all.

Summing up: Reitmans was hurt by the recession but business is picking up. The dividend is safe and the shares offer modest capital gains potential.

Action now: Buy. – G.P.

 

Return to the table of contents

APRIL UPDATES

Here are the updates for this issue. All prices are as of the close of trading on April 23 unless otherwise specified.

BCE Series Y Floating Rate First Preferred Shares (TSX: BCE.PR.Y)

Type: Floating rate preferred shares
Trading symbol: BCE.PR.Y
Exchange: TSX
Current price: $21.76
Originally recommended: Dec. 23/09 at $18.49
Credit Rating: S&P, DBRS: P2 low
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.bce.com

Comments: These floating rate preferreds were recommended at a price of $18.49 in December. They have now moved up almost 18% to $21.76. The dividend, which floats with an annual rate equal to 80% of Prime adjusted monthly, is still 56c so the yield is a paltry 2.57%, down from 3% at the time of our recommendation. Obviously, investors are willing to settle for a lower return now in exchange for the anticipated dividend increases.

As far as safety is concerned, the quality of the Series Y shares is, if anything, improving. The outlook for BCE is particularly encouraging and analysts have been raising their targets on the common stock. The preferred dividends are safe. I would not, however, be an aggressive buyer of BCE.PR.Y at these levels. Governments are going to make sure that interest rate increases are gradual and controlled. The dividend increases are likely to be small but regular. So I would not chase the stock. Also, keep in mind that there is a cap. BCE can call the issue at any time at a price of $25.50 in cash.

Action now: The BCE Series Y Preferred Shares are a Hold at $21.76. – T.S.

National Bank of Canada (TSX: NA, OTC: NTIOF)

Type: Common stock
Trading symbol: NA, NTIOF
Exchange: TSX, Pink Sheets
Current price: C$64.01, US$63.84
Originally recommended: March 22/06 at C$63.60, US$55.44
Credit Rating: DBRS: AA (low)
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.bnc.com

Comments: National Bank turned in an extremely good 2010 first quarter (Canadian banks have an Oct. 31 year-end). After adjustment for unusual items, operating cash earnings came in at $1.55 a share versus $1.40 the previous quarter and well above the $1.43 analysts were expecting. The Tier 1 capital ratio increased to 12.5% and return on equity (ROE) was 18%. Most important, there were signs that National is bolstering its retail network to help drive revenue growth.

The numbers were good across the board. Personal and Commercial results were better than anticipated due to higher spreads and Financial Markets profit was up 95% year-over-year. Loan loss provisions of $43 million were far less than the $90 million some forecasters were looking for. It’s interesting to note that Quebec’s credit experience continues to be much better than the rest of Canada.

I think that National’s emphasis on its more lucrative retail operations is going to pay off. In the past, the bank’s profits have been skewed. In 2009, 58% of the earnings came from the Wholesale division, which includes trading revenues. That is expected to drop to less than 40% in 2011 as a better balance is achieved. Consequently we should see earnings of about $5.60 a share in 2010 and as much as $6.50 in 2011. The dividend of $2.48 is safe and Dominion Bond Rating Service (DBRS) is maintaining its AA (low) rating.

The stock has had a good run and is now at $64 but I believe there is still upside potential. Here at Income Investor we do not normally set targets (our primary goal is income, not capital gains) but it’s no secret that the Street expects NA to trade at $68 within a year. Currently the shares yield 3.87%, equal to about 5.4% from a bond after adjustment for the dividend tax credit.

Action now: National Bank is a Buy for income and growth. – T.S.

Colabor Group Inc. (TSX: GCL, OTC: COLFF)

Type: Common stock
Trading symbol: GCL, COLFF
Exchange: TSX, Grey Market
Current price: C$12.40, US$12.35
Originally recommended: March 25/09 at C$8.95, US$7.13
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.colabor.com

Comments: Colabor Group issued its fourth-quarter and year-end results recently. The figures were skewed because of the fact the company converted from a trust to a corporation in August. However, Colabor provided investors with a breakdown of what the key results would have looked like had it been a corporation for the full year.

Fully diluted earnings per share would have come in at $1.06, slightly below the current dividend of $1.08. However, cash flow per fully diluted share was $1.59 which translates into a payout ratio of 68% on that basis. Sales were up 3.17% for the year, despite the recession, while EBITDA improved by 6.29%. The company did not offer any guidance for the 2010 fiscal year beyond saying that it is cutting costs as a way of dealing with the loss of a significant customer.

The share price has held up well and the stock is now trading at close to its highest point since fall, 2006. Even at these levels, the yield remains attractive at 8.7%. However, I do not advise new purchases at this price due to the high payout ratio and the lack of any clear guidance for the coming year.

With the capital gain plus dividends, we are ahead about 40% on this stock in slightly more than a year.

Action now: Hold.

 

Return to the table of contents

YOUR QUESTIONS

Target prices

Q – I have appreciated your advice for years. About one-third of my income will possibly come from investment savings after my retirement, probably in 2012. At the present time, my difficulty is to decide which investments with a capital gain should be sold in order to have cash for your new recommendations. In The Income Investor, would you provide us with estimated target values, similar to the Internet Wealth Builder? – Peter L.

A – We don’t usually set targets in Income Investor because the whole point of the newsletter is about cash flow, not capital gains. What we are looking for are stable securities that are expected to maintain or increase yields. When we also benefit from a capital gain, we regard it as a bonus. My suggestion, therefore, is that you focus on yield in making your buy-sell decisions. If you find a security of comparable quality that offers a higher yield, a switch is in order. – G.P.

New trust tax

Q – Has the government said how the new 2011 income trust tax will be calculated as far as the trust is concerned and as far as the shareholder is concerned? – Ian S.

A – The tax will be imposed on the trust itself (assuming any still exist at that point), in the same way as corporation tax. Shareholders will not be taxed directly but their payments will be reduced in most cases because there will be less money, after tax, to pay out.

On the positive side, trust distributions will be treated as dividends after Jan. 1, 2011 which means they will qualify for the dividend tax credit. As a result, the after-tax amount received in non-registered accounts may not drop significantly, if at all. The biggest losers will be investors who hold trust units in registered plans and foreign residents since the dividend tax credit won’t apply in these cases. – G.P.

Tax treatment of REITs

Q – Re the February recommendation to buy CREIT, Gavin Graham wrote: “Part of this reflects the absence of the dividend tax credit for REIT distributions, which are largely (80%+) ordinary income with the remainder treated as capital gains and/or return of capital”.

I was under the impression that all distributions from income trusts after 2010 would be dividends and hence subject to the dividend tax credit. You seem to imply that election would be up to each income trust. – John L.

A – It appears you have lumped in REITs with all other income trusts. That is not the case. REITs that meet government requirements (which we expect CREIT will do) are specifically exempted from the new tax. The flip side is that REIT distributions will continue to be treated as they have been in the past for tax purposes. So their payments will not be eligible for the dividend tax credit (unless some portion of the distribution qualifies as a dividend which is not usually the case with REITs). – G.P.

Which to buy?

Q – In the February Income Investor you recommend REF.UN, the Canadian REIT. Since I do want some REIT income, I am debating buying REF.UN or the iShares REIT ETF which trades on the TSX as XRE. To me, it seems that XRE would be better as it is more diversified than holding a single REIT. Could you please comment on this? – Barry M.

A – The problem with XRE is that 38.5% of the assets are invested in two REITs: RioCan and H&R. RioCan is coming off a bad year and there has even been speculation it might have to cut its distribution although I consider that to be unlikely. H&R is doing better now but it went through a financial crunch last year.

XRE’s distributions in 2009 were 64c a unit. The payments vary each quarter but using that figure and a recent price of $12.15 a share, the projected yield for this year is 5.27%. That’s a little better than CREIT’s projected yield of 4.9% but offsetting that is the fact CREIT makes predictable monthly payouts.

Those are the pros and cons. It’s your call. – G.P.

 

That’s all for this month. Look for the May Update Edition during the week of May 10. The next regular issue will be published on May 19.

Best regards,
Gordon Pape, editor-in-chief

In this issue:

CANADIAN OIL SANDS STILL LOOKS GOOD

By Gavin Graham, Contributing Editor

The first column that I wrote for The Income Investor five years ago recommended buying units of Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF). At the time, I commented that although it didn’t have the highest yield in the energy sector, the trust had the potential to increase its payout over time. That would lead to an increase in cash flow as well as an upward move in the share price as other investors were attracted to the increasing profits and distributions generated by the company.

I am pleased to say that, in this case at least, the theory proved correct. I recommended COS at $16.85 in March 2005. At the time the units paid a quarterly distribution of 10c, or 40c per unit annualized. Although there have been ups and downs along the way, the current distribution has more than tripled to 35c a unit, while the share price has almost doubled to $30.93 (price as of April 23). This compares favourably with both the broader stock market, where the S&P/TSX Composite Index has risen by less than 35% since March 2005, and with the Energy Trust Index, which has actually fallen over the same period.

Of course, there has been volatility along the way. Less than two years ago, with oil nudging US$148 per barrel, Canadian Oil Sands was trading over $50 and distributing $1.25 per quarter. Nonetheless, it has proved to be a very rewarding investment for those who stayed the course. Let’s examine some the reasons why this proved to be the case and what the outlook is for the next five years.

Why we liked it: The reason that the managers at Guardian Capital’s income funds have owned Canadian Oil Sands for the last dozen years is very simple. As long as the price of oil remained above US$25 per barrel, the trust, as the owner of the largest stake (36.74%) in the Syncrude oil sands consortium, would be profitable. It was the original oil sands development with its infrastructure already in place and did not face the same cost pressures as the new projects that were being built to take advantage of the higher oil prices in the past decade.

The other reason for liking the trust was that it was expanding production. The Stage 3 expansion increased Syncrude’s output (and Canadian Oil Sands’ share) by one-third to 350,000 barrels a day. Thus, even if the price of oil did not increase, Canadian Oil Sands’ revenues and profits would rise. Once the capital expenditure on the expansion was finished, the trust would have more cash available to distribute to its investors.

Furthermore, to reduce the risk of its expensive Stage 3 expansion, Canadian Oil Sands had hedged the oil price it received by selling its production in the forward market. The trust also hedged its U.S. currency exposure to ensure that it received enough cash to pay for the expansion, whatever happened to the oil price and currencies. As the oil price and the Canadian dollar were both appreciating while Stage 3 was being built, the trust surrendered potential profits for a guarantee that it would have enough cash. Once the expansion was completed, although (as with virtually every other oil sands project) it was both late and over budget, these hedges were allowed to expire.

Thus investors in Canadian Oil Sands between 2005 and 2008 received a triple bonus. First, Syncrude’s oil production increased by one third; second, the price of oil more than doubled; and last, the oil and currency hedges that Canadian Oil Sands had sensibly put in place expired.

Add to this the fact that the price of gas, which Syncrude uses to boil up the thick molasses-like bitumen that comprises the oil sands, actually fell by half during this period. Gas prices had spiked to nearly US$15 per million cubic feet (mcf) in the aftermath of Hurricane Katrina in October 2005. But the price fell rapidly after that as new supplies of shale gas and imports of liquefied natural gas (LNG) emerged to replace lost supplies.

When all this is added together, it is easy to see how distributions rose more than 12 times from 10c to $1.25 per quarter while the share price more than tripled.

Risk factors: As with any resource-based investment, the value of the underlying commodity is the most important factor influencing share price movement. When the price of oil collapsed during the recession, falling from US$148 per barrel in June 2008 to US$38 in February last year, so did Canadian Oil Sands’ profits and distributions. The total annual distribution rose steadily from 40c per unit in 2005, through $1.10 in 2006, $1.65 in 2007, and culminated in a high of $3.75 in 2008. But when oil prices plunged, the distribution was cut sharply to 90c last year as earnings fell from $1.4 billion in 2008 to $433 million in 2009.

On another front, environmental protestors were stirred to action when several hundred migrating ducks were trapped in the oily residues of Syncrude’s tailings ponds. Also, concerns were expressed that the process of strip mining which extracts the oil sands for processing at Syncrude’s Fort McMurray plant was a major generator of carbon emissions and would be adversely affected by new U.S. legislation penalizing oil produced by “dirty” (i.e. high CO2 emitting) sources.

From a financial perspective, the new Alberta royalty regime introduced by Premier Ed Stelmach in 2009 was perceived as a negative, even though Syncrude was exempted from the legislation as it was organized under a different royalty system. Also, investors worried about plans to build an expensive new bitumen upgrader to transform the lower grade product of Syncrude into higher value synthetic light oil.

Yet there were signs that perhaps the pessimism was overdone. In August 2009, Chinese state-controlled oil giant PetroChina paid $1.9 billion for a 60% stake in Athabasca Oil Sands, which, while it had extensive oil sands acreage near Fort McMurray, had no production and would need to spend several billion dollars to start operations by 2015. Applying the same valuation per barrel of oil equivalent (boe) to Canadian Oil Sands implied a substantial premium above the existing share price.

Then in October, 2009, ConocoPhillips, the third-largest U.S. oil major, indicated it was looking at selling its 9% stake in Syncrude to help raise US$10 billion to reduce the debt burden taken on in its ill-timed acquisition of gas producer Burlington Resources in 2006. Some investors were concerned that Canadian Oil Sands, the logical buyer of the stake, would have to issue shares to fund the purchase, which was estimated to cost $3.65 billion, although brokers’ analysts estimated that such a purchase would not be dilutive as long as Canadian Oil Sands didn’t pay more than $4.1 billion.

Recent developments: Earlier this month, the buyer of Conoco’s stake was announced. It was not Canadian Oil Sands; instead another state-controlled Chinese oil company, Sinopec, bought the stake. The price was US$4.65 billion, showing that rising oil prices as the world economy revives have helped to increase the value of Canadian Oil Sands’ assets.

As commodities guru Don Coxe at Nesbitt Burns pointed out, what this also demonstrated was that the emerging economies of China, India, and Brazil, with growing middle classes driving their ravenous appetite for raw materials, are willing to pay high prices for secure, long-life natural resource assets in politically stable countries like Canada and Australia. Analysts doing the math, such as Randy Ollenberger at BMO Nesbitt Burns, announced that Canadian Oil Sands, using the same valuation as Sinopec paid, was worth $37 per share. He also pointed out that the price of Canadian Oil Sands had been depressed due to fears of an equity issue to pay for the Conoco stake, and that they should now be re-evaluated.

Siren Fisecki, the spokesperson for Canadian Oil Sands, announced in February that, while Syncrude still planned to increase its output by 2020, it would now look to raise its daily output to 540,000 barrels per day instead of 500,000 from its present 350,000 by not building the expensive upgrader. This would result in “substantial savings”, he said. “We’ve always talked about expanding. It’s just how we will expand (that) has evolved and changed.”

Instead, Syncrude will raise bitumen production by 115,000 barrels a day and add another 75,000 barrels by streamlining its existing plant. Apart from the high cost, one of the reasons given by analysts for this move is that the traditional 20%-30% discount that “heavy” oil such as that produced from bitumen sold in the U.S. has narrowed to 10%, thus removing the profit margin for upgraders. This was due to a sharp decline in exports of heavy oil from traditional U.S. suppliers such as Mexico, as the massive Cantarell field in the Gulf of Mexico has seen output more than halve in the last five years. There has also been a decline in shipments from Venezuela, which like Canada produces heavy oil from bitumen. So U.S. refineries have turned to Canada to fill the gap.

Finally, Canadian Oil Sands has announced that it will transform itself into a corporation once the change in trust taxation takes place on Jan. 2, 2011 as there will no longer be any benefit to remaining a trust. There will be no change in its quarterly distribution policy, which has always varied widely dependent upon the price of oil and the U.S. dollar exchange rate.

Summing up: The recent Sinopec purchase of Conoco’s 9% stake and the value it implies, the cancellation of the upgrader by Syncrude, and the plans to expand production by 40% over the next decade have removed uncertainty and reinforced the attractiveness of the oil sands as a strategic asset. All this ensures that there will be growth in revenues and distributions regardless of what the oil price does. In other words, Canadian Oil Sands is in a very similar position to when we made our initial recommendation five years ago and should prove as rewarding for investors as the last five years have done.

Action now: Buy. Based on Friday’s closing price the units currently yield 4.53%.

Gavin Graham is one of Canada’s best-known financial commentators and Global Strategist for Excel Funds.

 

Return to the table of contents

DON’T SIT ON YOUR CASH

By Tom Slee, Contributing Editor

Despite growing concern that Greece may actually default on its sovereign debt, North American interest rates continue to drift sideways. In fact, they are not responding to any news, good or bad. The reason, I suspect, is that institutional investors are confused. Most economic indicators are encouraging but central banks keep giving mixed signals.

For instance, Federal Reserve Chairman Ben Bernanke has been reassuring people that interest rates are going to remain low until the recovery is well underway. That seems clear enough but a few weeks ago he suddenly raised the U.S. discount rate, which is the rate the Fed charges for emergency loans to banks, by 25 basis points (0.25 percentage points).

The Bank of Canada, torn between inflation and a strong loonie, has everybody guessing. Last week’s statement removed the Bank’s commitment to hold its key target rate at 0.25% until the end of June, prompting immediate speculation that we could see a quarter-point hike as early as the June 1 policy announcement. But then the March inflation numbers came in much lower than expected, causing some analysts to suggest the Bank may hold off for a while. In short, there is no clear direction.

Not that our bond markets have been quiet. On the contrary, underwriters are working overtime to feed a fierce demand for new issues. Money managers seem happy to gobble up any IPO or refinancing regardless of relatively unattractive returns and, in some cases, lower quality. Overseas investors are also willing to buy anything as long as it’s stamped Canadian.

So, as you would expect, the federal government, the provinces, and Canadian corporations have been busy raising capital. New corporate bonds were hitting the street at the rate of more than $2 billion a week during March as Royal Bank, Husky, and Manulife, amongst others, filled their coffers.

Normally all this activity would drive interest rates higher. For now, though, supply and demand remain balanced. There is no significant movement in the aftermarket.

Where does this leave small fixed-income investors? Well, I still think that U.S. and Canadian interest rates are going to inch up this year regardless of how the economies perform. The huge budget deficits will take a toll in the second half and we are bound to see a flood of government bonds to cover the shortfall. At the same time, foreign investors are likely to divert at least some of their buying to U.S. markets and take advantage of a resurgent greenback as the Federal Reserve gets its house in order. That will drive Canadian bond prices down and yields higher.

My suggestion, therefore, is that investors needing more income should start extending term. There is no point in sitting on cash earning 1.5% or less and waiting for a sudden surge in rates. With Mr. Bernanke’s foot on the brake, it’s going to be a gradual trend. Above all, shop carefully and stay with top-quality issues. Be patient, there are some good values out there.

For example, the Bell Aliant 4.95% debentures maturing in February 2014, with a BBB high rating, were recently trading at $105 to yield 3.46%. With less than a five-year term they are partially protected against any sudden slump in bond prices.

Bond ladders

I have the same advice for readers who are creating or updating their mid-term bond ladders. Maintain your program. Forget about market timing. To recap briefly, a ladder consists of a series of bonds, usually of equal weight, that mature in sequence. This arrangement provides you with an average yield, somewhere between the short and medium bond market returns. In addition, because a portion of the portfolio comes due each year or two, you always have cash available to take advantage of rising rates. Conversely, because the bulk of your money remains invested, you still earn an above-average total return even if any proceeds are reinvested at a lower rate.

For example, say you owned $100,000 worth of Canada bonds maturing in 2012 yielding 1.50%, $100,000 in Canadas of 2014 paying 2.5%, and a further $100,000 in bonds due in 2016 and yielding 3%. In this case, your overall yield is 2.33% and the average term is four years. Yet you have money coming due in two years. When that happens, you can reinvest the proceeds in the Canadas of 2018 and maintain your average four-year term. If returns have plunged and the new bonds earn only 1% your overall yield is still a better-than-average 2.07%.

This is a popular fixed-income technique but recently some readers, presumably still hunkered down because of the crisis, have been asking whether they should resume “ladder” investing. The answer is yes, absolutely. I think that long-term income-seeking investors should always have a bond ladder in place, although it’s tough to maintain when we are in a crisis and safety becomes an overriding factor. The important thing is to stay with the process. Market timing defeats the purpose. You usually end up heavily in cash waiting for rates to change, always a dangerous fixed-income strategy.

Buying and selling bonds

Readers have also asked about the mechanics of buying and selling bonds at what is known as the retail level. Here’s the story but keep in mind that this is a sprawling, unregulated market with no hard and fast prices.

Let us assume that an advisor has recommended the Telus Corporation 5.95% debentures due April 15, 2015, and you want to buy $20,000 worth of the issue. As there are no reliable published corporate bond prices, start by asking your broker for a quote. He will contact his trading desk to see whether there are any of these bonds in the firm’s inventory. If not, the trader can estimate a current market level although he is going to be reluctant to shop for a small amount of bonds without a firm order and a lot of latitude in the price. The firm is not going to run the risk of owning these bonds if you change your mind. So the best approach is to place a firm order with clear limits and if the broker is unable to provide a “fill” ask him to suggest some comparable alternatives with an A credit rating or better, although a BBB+ is sometimes acceptable.

On the sell side the process is reversed with your broker likely to offer a good price if his trader can dispose of your bonds quickly or is willing to keep them in inventory. Government of Canada bonds, for instance, are always liquid and easy to move. Obscure long-term corporate issues may have almost no market at all.

It’s all very unsatisfactory because there is no public auction market. Traders bid and offer amongst themselves. Prices vary depending on the size of order and sometimes how keen a buyer or seller is to complete a transaction. For instance, sinking funds have quotas of bonds to retire and sometimes pay outlandish amounts for relatively small parcels to complete their fill. In addition, because the firm you are dealing with is buying or selling for its own account, any commission forms part of the price. That places your broker in an odd sort of conflict of interest. He/she is supposed to provide you with good service and a competitive price while at the same time the firm is making a profit on the transaction.

I am not suggesting that the process is unethical or that the broker is trying to gouge you, although there are some sharp practices. It’s just that the bond market is an unregulated jungle. Institutions protect themselves by having full-time seasoned bond traders on staff.

My suggestion is that you should, if possible, shop around. Try and get several quotes. Then set firm price limits and remain patient. A good broker should be able to provide you with alternative offers. There are always plenty of comparable bonds available.

New bond issues

The new issue side of the market is booming these days. Here there are time constraints and you have to act quickly but the prices, at least initially, are firm and readily available. Moreover, the brokers’ fees have already been paid by the issuing company. New issues work like this:

A corporation wishing to raise capital retains an underwriter who “sounds” the market by unofficially consulting with major institutions and establishes whether there is a demand for the offering, how much investors can absorb, and on what terms. At this stage, the news of an impending deal usually becomes widespread and you can tell your broker that you may have an interest depending on the term, coupon, price, and resulting yield. By the way, most new issues are usually very popular because the underwriters price them below the market in order to spur demand. In fact, they are often “hot” and some sell out within an hour. Some are even over-subscribed and go to a premium.

The result is that small investors usually stand little chance of getting their orders filled at issue price. My suggestion, therefore, is that in addition to having your broker keep you up to date about any pending issues, make sure he/she tells you about the immediate aftermarket. You know the issue price and can tell if there has been much price movement. If the issue laid an egg and actually dropped in value, you could step in and get a bargain.

Preferred shares

With higher interest rates now an almost certainty, most preferred share prices have been slipping. This entire market has weakened. Let’s face it, preferreds served us well with safe above-average returns during the market collapse and record low interest rates. But straight preferreds, with their fixed dividends, trade like very long bonds and I would expect them to move even lower during the balance of this year.

Floating rate preferreds are another matter. Their dividends increase as interest rates rise and as a result they are now looking much more attractive. Investors have been buying them despite their relatively poor yields in order to earn a better return down the road. In some cases their prices have jumped due in part to the fact that top-quality floating rate preferreds are few and far between.

For comments the BCE floating rate preferreds that I have recommended in December, see the Updates section.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed-income securities.

 

Return to the table of contents

APRIL?S TOP PICKS

Here is our top pick for this month. Prices are as of the close of trading on Friday, April 23 unless otherwise specified.

Reitmans (Canada) Ltd. (TSX: RET.A, OTC: RTMAF)

Type: Common stock
Trading symbol: RET.A, RTMAF
Exchange: TSX, Grey Market
Current price: C$18.65, US$18.51 (April 21)
Entry level: Current price
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.reitmans.ca

The business: Reitmans operates 977 retail stores across Canada under its own name as well as other banners such as Smart Set, RW & CO., Penningtons, Addition-Elle, Thyme Maternity, and Cassis. All except RW & CO focus exclusively on women’s fashions.

The company traces its history back to the early 1900s when Herman and Sarah Reitman ran a small department store in Montreal. The Reitmans Company was founded after a second store was opened in 1926 and has grown steadily since to become one of the largest publicly-traded retail companies in Canada.

The security: We are recommending the common shares of Reitmans Ltd. which trade on the TSX under the symbol RET.A. These are non-voting shares and the company remains under the control of the Reitman family, with Jeremy H. Reitman the president.

Why we like it: For starters, the timing is right. Like many retailers, Reitmans was hard-hit by the recession. Earnings per share (EPS) for the 2010 fiscal year (ending Jan. 30) came in at 98c, down from $1.21 in fiscal 2009. Although the company reported a small 0.5% increase in revenue for the year, to $1.057 billion, same-store sales were down 1% and operating earnings fell 12.4%.

However, by the fourth quarter it was evident that a turnaround was taking place as the economy began to recover and people returned to the malls. Sales for the quarter were up 2.4% year-over-year and same-stores sales increased 1.5%. Net earnings for the quarter were up 56.9% with EPS coming in at 21c.

Everything points towards a continued rebound in the company’s business and the movement of the share price in recent months reflects that. The stock traded in a narrow range of $16 to $17 from October to late March when the year-end results came out. From there it spiked to the current level.

The second reason we like this stock, and the one of greatest significance to readers of this newsletter, is a healthy dividend of 72c a year. Based on a share price of $18.65 that represents a yield of 3.86%. I believe the dividend is safe and if business continues to improve we could see increases down the road.

Financial highlights: In an analysis published after the year-end results came out, RBC Capital Markets increased its projection for fiscal 2011 EPS to $1.27 from $1.22. For fiscal 2012, the brokerage firm predicts earnings of $1.47 per share, up from $1.40.

In the report, analyst Tal Woolley and associate Daniel Armstrong highlighted the company’s strong liquidity position which they say “bodes well for future shareholder value creation opportunities” such as acquisitions and buybacks. The company currently has a normal course issuer bid in place to buy back up to 2.7 million class A shares or 5% of the total. They estimated that the company should be in a position to deliver $100 million in free cash flow this year.

The balance sheet is in excellent shape. Reitmans reported cash holdings of almost $230 million at the end of the 2010 fiscal year and has long-term debt of only $11.4 million in the form of a mortgage on the company’s distribution centre. For all practical purposes, the firm is debt-free.

Risks: As we saw during the recently-completed fiscal year, Reitmans is vulnerable to economic downturns. A double-dip recession would slow the company’s growth and reduce the chances of a dividend increase or some other action to increase share value.

There is also some currency risk. Reitmans pays for much of its merchandise in U.S. dollars. When the loonie is strong, it works to the company’s advantage but when it drops sharply the result can be increased costs. Reitmans employs some currency hedges to mitigate this but reported that in fiscal 2010 fluctuating exchange rates had a negative impact of about $10 million on gross margin.

Distribution policy: Dividends of 18c a share are paid quarterly in January, April, July, and October.

Tax implications: Payments are eligible for the dividend tax credit if held by Canadians in non-registered accounts.

Who it’s for: The shares are suitable for investors who want to diversify their divided-paying stock portfolio with a top-quality retailer. We rate it as moderate risk although the shares would be vulnerable to a possibly significant pull-back in an economic downturn.

How to buy: The shares trade primarily on the Toronto Stock Exchange. Volume can be relatively light, sometimes less than 50,000 per day, but you should have no problem being filled. Reitmans also trades in the Grey Market in the U.S. as RTMAF but volume there is very low and some days there are no trades at all.

Summing up: Reitmans was hurt by the recession but business is picking up. The dividend is safe and the shares offer modest capital gains potential.

Action now: Buy. – G.P.

 

Return to the table of contents

APRIL UPDATES

Here are the updates for this issue. All prices are as of the close of trading on April 23 unless otherwise specified.

BCE Series Y Floating Rate First Preferred Shares (TSX: BCE.PR.Y)

Type: Floating rate preferred shares
Trading symbol: BCE.PR.Y
Exchange: TSX
Current price: $21.76
Originally recommended: Dec. 23/09 at $18.49
Credit Rating: S&P, DBRS: P2 low
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.bce.com

Comments: These floating rate preferreds were recommended at a price of $18.49 in December. They have now moved up almost 18% to $21.76. The dividend, which floats with an annual rate equal to 80% of Prime adjusted monthly, is still 56c so the yield is a paltry 2.57%, down from 3% at the time of our recommendation. Obviously, investors are willing to settle for a lower return now in exchange for the anticipated dividend increases.

As far as safety is concerned, the quality of the Series Y shares is, if anything, improving. The outlook for BCE is particularly encouraging and analysts have been raising their targets on the common stock. The preferred dividends are safe. I would not, however, be an aggressive buyer of BCE.PR.Y at these levels. Governments are going to make sure that interest rate increases are gradual and controlled. The dividend increases are likely to be small but regular. So I would not chase the stock. Also, keep in mind that there is a cap. BCE can call the issue at any time at a price of $25.50 in cash.

Action now: The BCE Series Y Preferred Shares are a Hold at $21.76. – T.S.

National Bank of Canada (TSX: NA, OTC: NTIOF)

Type: Common stock
Trading symbol: NA, NTIOF
Exchange: TSX, Pink Sheets
Current price: C$64.01, US$63.84
Originally recommended: March 22/06 at C$63.60, US$55.44
Credit Rating: DBRS: AA (low)
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.bnc.com

Comments: National Bank turned in an extremely good 2010 first quarter (Canadian banks have an Oct. 31 year-end). After adjustment for unusual items, operating cash earnings came in at $1.55 a share versus $1.40 the previous quarter and well above the $1.43 analysts were expecting. The Tier 1 capital ratio increased to 12.5% and return on equity (ROE) was 18%. Most important, there were signs that National is bolstering its retail network to help drive revenue growth.

The numbers were good across the board. Personal and Commercial results were better than anticipated due to higher spreads and Financial Markets profit was up 95% year-over-year. Loan loss provisions of $43 million were far less than the $90 million some forecasters were looking for. It’s interesting to note that Quebec’s credit experience continues to be much better than the rest of Canada.

I think that National’s emphasis on its more lucrative retail operations is going to pay off. In the past, the bank’s profits have been skewed. In 2009, 58% of the earnings came from the Wholesale division, which includes trading revenues. That is expected to drop to less than 40% in 2011 as a better balance is achieved. Consequently we should see earnings of about $5.60 a share in 2010 and as much as $6.50 in 2011. The dividend of $2.48 is safe and Dominion Bond Rating Service (DBRS) is maintaining its AA (low) rating.

The stock has had a good run and is now at $64 but I believe there is still upside potential. Here at Income Investor we do not normally set targets (our primary goal is income, not capital gains) but it’s no secret that the Street expects NA to trade at $68 within a year. Currently the shares yield 3.87%, equal to about 5.4% from a bond after adjustment for the dividend tax credit.

Action now: National Bank is a Buy for income and growth. – T.S.

Colabor Group Inc. (TSX: GCL, OTC: COLFF)

Type: Common stock
Trading symbol: GCL, COLFF
Exchange: TSX, Grey Market
Current price: C$12.40, US$12.35
Originally recommended: March 25/09 at C$8.95, US$7.13
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.colabor.com

Comments: Colabor Group issued its fourth-quarter and year-end results recently. The figures were skewed because of the fact the company converted from a trust to a corporation in August. However, Colabor provided investors with a breakdown of what the key results would have looked like had it been a corporation for the full year.

Fully diluted earnings per share would have come in at $1.06, slightly below the current dividend of $1.08. However, cash flow per fully diluted share was $1.59 which translates into a payout ratio of 68% on that basis. Sales were up 3.17% for the year, despite the recession, while EBITDA improved by 6.29%. The company did not offer any guidance for the 2010 fiscal year beyond saying that it is cutting costs as a way of dealing with the loss of a significant customer.

The share price has held up well and the stock is now trading at close to its highest point since fall, 2006. Even at these levels, the yield remains attractive at 8.7%. However, I do not advise new purchases at this price due to the high payout ratio and the lack of any clear guidance for the coming year.

With the capital gain plus dividends, we are ahead about 40% on this stock in slightly more than a year.

Action now: Hold.

 

Return to the table of contents

YOUR QUESTIONS

Target prices

Q – I have appreciated your advice for years. About one-third of my income will possibly come from investment savings after my retirement, probably in 2012. At the present time, my difficulty is to decide which investments with a capital gain should be sold in order to have cash for your new recommendations. In The Income Investor, would you provide us with estimated target values, similar to the Internet Wealth Builder? – Peter L.

A – We don’t usually set targets in Income Investor because the whole point of the newsletter is about cash flow, not capital gains. What we are looking for are stable securities that are expected to maintain or increase yields. When we also benefit from a capital gain, we regard it as a bonus. My suggestion, therefore, is that you focus on yield in making your buy-sell decisions. If you find a security of comparable quality that offers a higher yield, a switch is in order. – G.P.

New trust tax

Q – Has the government said how the new 2011 income trust tax will be calculated as far as the trust is concerned and as far as the shareholder is concerned? – Ian S.

A – The tax will be imposed on the trust itself (assuming any still exist at that point), in the same way as corporation tax. Shareholders will not be taxed directly but their payments will be reduced in most cases because there will be less money, after tax, to pay out.

On the positive side, trust distributions will be treated as dividends after Jan. 1, 2011 which means they will qualify for the dividend tax credit. As a result, the after-tax amount received in non-registered accounts may not drop significantly, if at all. The biggest losers will be investors who hold trust units in registered plans and foreign residents since the dividend tax credit won’t apply in these cases. – G.P.

Tax treatment of REITs

Q – Re the February recommendation to buy CREIT, Gavin Graham wrote: “Part of this reflects the absence of the dividend tax credit for REIT distributions, which are largely (80%+) ordinary income with the remainder treated as capital gains and/or return of capital”.

I was under the impression that all distributions from income trusts after 2010 would be dividends and hence subject to the dividend tax credit. You seem to imply that election would be up to each income trust. – John L.

A – It appears you have lumped in REITs with all other income trusts. That is not the case. REITs that meet government requirements (which we expect CREIT will do) are specifically exempted from the new tax. The flip side is that REIT distributions will continue to be treated as they have been in the past for tax purposes. So their payments will not be eligible for the dividend tax credit (unless some portion of the distribution qualifies as a dividend which is not usually the case with REITs). – G.P.

Which to buy?

Q – In the February Income Investor you recommend REF.UN, the Canadian REIT. Since I do want some REIT income, I am debating buying REF.UN or the iShares REIT ETF which trades on the TSX as XRE. To me, it seems that XRE would be better as it is more diversified than holding a single REIT. Could you please comment on this? – Barry M.

A – The problem with XRE is that 38.5% of the assets are invested in two REITs: RioCan and H&R. RioCan is coming off a bad year and there has even been speculation it might have to cut its distribution although I consider that to be unlikely. H&R is doing better now but it went through a financial crunch last year.

XRE’s distributions in 2009 were 64c a unit. The payments vary each quarter but using that figure and a recent price of $12.15 a share, the projected yield for this year is 5.27%. That’s a little better than CREIT’s projected yield of 4.9% but offsetting that is the fact CREIT makes predictable monthly payouts.

Those are the pros and cons. It’s your call. – G.P.

 

That’s all for this month. Look for the May Update Edition during the week of May 10. The next regular issue will be published on May 19.

Best regards,
Gordon Pape, editor-in-chief