Income trusts are still alive and kicking, despite last fall’s surprise proposal by federal Finance Minister Jim Flaherty to remove their preferential tax treatment. Indeed, some fund managers say there will be value in a select number of trusts regardless of Ottawa’s actions.

“Right now, there is a kind of ‘warrant’ value in the trust securities that we hold,” says Oscar Belaiche, manager of Dynamic Focus + Small Business Fund and vice president of Toronto-based Goodman & Co. Investment Counsel.

“The question is: will the government proceed with its plan as proposed or will there be an amendment to the plan?” he says. “That warrant could be worthless or worth, say, 10%. By investing in our fund, or others, you will own quality businesses using the trust structure that over time should grow in value.”

Dynamic is currently part of the Canadian Association of Income Trust Investors, which is lobbying the government to reconsider its proposal. If successful, “there could be a valuation bump in price of the trusts,” he says, “although we don’t know for sure because it’s a political process.”

If the government’s plan to change the taxation of trusts in 2011 goes ahead, however, many trusts probably will convert to corporations. “These are sound, quality businesses, regardless of the structure. We will continue to have a small-business fund, but it will have more common equity than trusts,” says Belaiche. “The outlook remains positive, from the point of view that we own good businesses at attractive prices. It’s not to say the value of the businesses has gone down, but the value of the income trust structure has been impacted, but not necessarily permanently. The fight is not over.”

Strategically, Belaiche has long been overweighted in business trusts, which account for 52% of his fund, and he avoided last year’s market rout by underweighting the beleaguered oil and gas sector, which accounts for 7.5% of the fund. The balance of the portfolio is composed of 17% real estate investment trusts, 15% equities, and small cash and private-equity real estate holdings.

“We don’t have a specific asset allocation. It’s all about going where we find the right opportunities and what we believe are the best total-return expectations adjusted for risk,” says Belaiche. “We were already in the business trust area, but it has become even more attractive, particularly subsequent to the turbulence caused by the Conservative government with its purported ‘tax fairness plan’.”

On the equity side of the 60-name fund, Belaiche likes Saxon Financial Inc. With more than $12 billion in assets, the firm is one of the fastest-growing asset managers in the country and has a solid record of earnings growth and profitability, Belaiche says: “It’s a very well-run business, has had good growth and was attractively priced when we entered into it. We’re comfortable continuing to own it.”

Acquired at its initial public offering in the fall of 2005 at $16.50 a unit, it is currently trading at $21.75. At 3.3%, its dividend yield is among the highest in the Dynamic fund.

Turning to business trusts, Belaiche favours Pizza Pizza Roy-alty Income Fund, the dominant pizza chain in Ontario. “It has steadily increased its distribution yield,” he says, noting the trust has raised it four times since its IPO in July 2005. The trust yields 9.95%.

Bought at its IPO at $10 each, the units now trade at around $8.75, but Belaiche is hanging on: “I like the business; it’s well run and managed. I’m comfortable with it, and we’ve done well with the high yield.”

In a similar vein, he likes Golf Town Income Fund. The firm is the world’s third-largest retail chain that sells golf equipment and accessories. “It’s gained market share from places like Canadian Tire. It’s growing very quickly,” says Belaiche, adding that the firm has raised its distribution three times since its IPO in late 2004 at $10 a unit.

The trust now trades at $12.50 and yields 9.2%.



It’s definitely time to be more defensive with income trusts, says Barry Morrison, manager of Talvest Millennium High Income Fund and chairman of Toronto-based Morrison Williams Investment Management Ltd.

The Talvest fund had long maintained a blend of 65% income trusts and 35% dividend-paying equities. In the wake of Flaherty’s proposal, however, the asset allocation has changed to 57% income trusts, 36% stocks and 7% cash. There are about 40 trusts and 35 equities in the fund.

@page_break@“Our immediate response was that we increased our real estate investment trust exposure to 15% from 12%,” says Morrison. “We were always overweighted in that sector because, longer term, we believe it is an excellent area.” Existing positions were increased in names such as Calloway REIT, Canadian REIT, RioCan REIT and H&R REIT.

At the same time, Morrison reduced the oil and gas trust exposure to 15% from 25% of the portfolio: “We didn’t like the technical trends in the sector. Some of our technical work pointed out that maybe the big four-year upward move in oil was over. We could be moving into a sideways or bear-market phase. So, it was prudent to take some money out of this market. We sold the trusts across the board.”

Longer term, however, Morrison says, the fundamentals look good. It’s merely a case of dodging the pain that the sector may experience in the short term. Some of his larger holdings include Canadian Oil Sands Trust, Vermillion Energy Trust and Zargon Energy Trust.

On the 20-name business trust side, Morrison favours firms with growth potential in their distributions. One of his favourites is Aeroplan Income Fund, which manages Air Canada’s Aeroplan loyalty program: “I like the management. I thought that once it got out from under the clutches of Air Canada, it would grow and expand. It has.”

Acquired at its IPO in July 2005 at $10, it is now trading at $19.10.

Another favourite is Liquor Stores Income Fund. The largest liquor store operator in Western Canada, it has 105 outlets, mostly in Alberta. Morrison bought it at the IPO at $10 in October 2004. It is now $18.60 and yields 7.5%. “It’s a well-managed business,” he says.

On the equities side, Morrison has holdings in the Big Five banks, as well as in Manulife Financial Corp. and Sun Life Financial Inc., all of which pay dividends of 2.8%-3.8% and provide income stability. He also likes growth-oriented names such as Tim Hortons Inc., one of the largest fast-food companies in Canada, which was spun off from of Wendy’s International Inc.: “It’s at about 75% capacity in Canada, but it’s just starting in the U.S.”

Bought at the IPO at $27 a share in March 2006, Morrison added to the holding in the past year. The stock is now $36.50. It has a 0.78% dividend, but Morrison expects that will grow: “It’s a game of picking companies that will grow and raise their dividends, and staying with them.”



The income trust sector may be battered but its prospects are looking better, says Sandy McIntyre, manager of Sentry Select Canadian Income Fund and senior vice president of Toronto-based Sentry Select Capital Corp.

“We’re starting the year with compressed valuations, while we started 2006 with extended valuations,” he says. “We’ve crushed a lot of optimism out of this market. When that happens, I become optimistic.”

Investors have to recognize that “this is still a very good asset class,” he says, adding that this year it could generate high single-digit to low double-digit returns. “We are looking at good businesses that can grow. The capital discipline of a trust model is a decent way to run a business.”

Like his peers, McIntyre has become defensive, especially regarding oil and gas. Although the sector’s median weight is 40.5% in the benchmark Scotia Capital income trust index, the Sentry fund has only 19.5% exposure.

“We began cutting back a year ago, and did so again in June 2006,” he recalls. He notes, however, some positive developments will show up later in 2007 and into 2008: reduced drilling activity for natural gas and the U.S. resuming the filling of its strategic energy reserves, which will absorb excess inventory. “This will put a base under prices,” says McIntyre. “With more cold weather, we could see further upside.”

One of his favourite holdings in a 74-name fund is Canadian Oil Sands Trust. Other prominent holdings are Vermilion Energy Trust and ARC Energy Trust.

Canadian Oil Sands, which owns 35.5% of the Syncrude project, has a 4.5% yield. A long-term holding, it is trading at $30. “We don’t stretch for yield,” says McIntyre. “We’re looking for a combination of growth and the underlying cash flow — and a reasonable current yield.”

Moreover, he notes, the firm’s low payout ratio of 30% and its strong balance sheet will help it weather the current weakness in prices. “And it has an ability to grow its distributions, going forward,” he says, noting production is rising by about 18% a year.

Meanwhile, McIntyre is bullish on business trusts, which are split between 15% in consumer-oriented trusts and 21.8% in industrial-oriented trusts.

A favourite in the first group is Parkland Income Fund, a distributor and retailer of gas, fuel oil and convenience stores, primarily located in small towns in Western Canada. “It’s a classic value play; it has a clean balance sheet and a payout less than its net income. And it invests back in its business to improve the quality of its products,” says McIntyre, noting the trust yields 7.2%. Bought in early 2003 at $12.50, it is now trading at $35.50.

On the REIT side, which accounts for 23% of the Sentry fund, McIntyre favours names such as Westfield REIT.

“We’ve moved into some of the emerging smaller-cap names,” he says, adding that he began taking a position in 2005 and has added along the way. “When you get these kinds of holdings, you help them grow over time.”

The diversified commercial REIT has most of its assets in Western Canada and yields 6.6%. IE