Financial Jungle

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You have to be a Vulcan to remain unrattled by the November blizzard that knocked the TSX index off by nearly 8%. All of a sudden, the market has become pessimistic, and rightfully so as many indicators are foreseeing a recession looming. It will suck if a recession storms in uninvited. After all, who will spoil us with dividend increases when cash flows aren’t there?

While many investors have their tongue frozen to the credit crunch pole, the conservative ones are now keeping their portfolios warm and toes-curled under a blanket of utility, consumer stable and health care stocks; ones that deliver essential products and services to the general population irrespective of the market cycle we’re in.

What are some of our basic needs? Food, water, electricity and heating. Last week, I highlighted Borelax Power Income Fund, which owns 10 power plants in Quebec and the state of New York. Staying on a similar theme, I recently invested a position in the Consumers’ Waterheater Income fund (CWI.un).

If you live in Toronto, you recognize that heat and hot water are two of the most elementary needs. CWI rents out 1.4 million natural gas-fired water heaters to 83% of residence in the Enbridge Gas Distribution network within the Greater Toronto area. A boring business, isn’t it? Which is why this investment is so exciting in my view, because mundane businesses tend to come with less baggage, and it’s easier to evaluate if they’re cheap.

CWI’s rental fees are bundled in the customers’ natural gas bills. Brilliant! Not only do they provide essential services, the fees are buried deep inside the monthly gas utility bills which everyone almost always pay in auto-pilot mode. Very few businesses are more vital and stable than CWI; S&P agrees. The trust receives a AAA credit rating and SR-2 stability rating given its conservative balance sheet and recession proof character.

CWI’s minimal capital expenditures are mostly geared toward renewing 5% or 6% of its asset base in a given year, because a typical waterheater has a 15-year lifespan. In addition, CWI has little operating risks. A partnership agreement with Direct Energy Marketing Limited means that nearly all of CWI’s service support is outsourced in exchange for 35% of the aggregate rental revenues.

What more can you ask for in an income trust? Capital expenditures are minimal, revenue stream is stable, customer base is growing, share count is in check, and bank balance is growing.

In fact, between 2003 and 2006, CWI’s vault swelled steadily from $17 millions to $39 millions without diluting shares or eroding debt-level. With the business flush with cash, CWI recently plunked down $10 millions as a 25% down payment to acquire Toronto Hydro Energy Services units for $41 million. This represents a 6% increase to the total installed waterheaters.

The growth potential doesn’t end there. According to their website:

Beyond the existing service arrangement, the Direct Energy relationship has the potential to bring new growth opportunities to the Fund. As Direct Energy expands its home services footprint, the opportunity arises to rent water heaters to these customers. In addition, should Direct Energy successfully establish a significant base of rental water heater customers elsewhere in Canada, the Fund has right of first refusal to acquire it.

Management foresees the rental rate to rise in tandem with the rate of inflation. Between that and the growing asset base, distribution should improve by about 5% a year. Each CWI unit delivers an annual distribution of $1.29. Based on Friday’s closing of $14.93, that’s a yield of 8.64%. Anything above a 9% yield for CWI is cheap in my book.

If you happen to purchase CWI, consider the tax consequence: CWI’s distributions are not as tax friendly as most other trusts. 97% is treated as interest income with only 3% is return of capital. It’s better to hold the trust in a tax-deferred account such as RRSP. Short of that, you could hold the trust in a non-registered account of the spouse in a lower tax-bracket.

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It’s a sad day yesterday as I eliminated my National Bank position after holding the stock for 21 months. Of course, it’s also one of the very first four stocks I purchased when I began my dividend-investing foray (the others were Power Financial, Bank of Nova Scotia and Saputo).

While the sentimental value of National Bank made the sell button excruciating to press, I felt it was the right decision in light of NA’s large asset-backed commercial paper burden relative to its market capitalization. The mounting writedowns should persist for several quarters, distracting management’s attention away from the day-to-day operations and growth strategies. Even without the distraction, NA’s geographical reach seems to be boxed within the Quebec province. Why don’t they just go buy something? I also have skepticisms against management, but let’s no go there.

Enough of my ranting. So, where to redeploy the proceeds? The choice is obvious: TD Bank. The more I read about the subprime fiasco and TD Bank, the more I like Ed Clark. Writedowns? What writedowns? You’d think Ed Clark is taking Tylenol to cure his ABCP migraine, but no! He’s taking Viagra to extend his reach into the United States. Officially with the Commerce Bancorp acquisition, TD blossoms to become the seventh largest bank in North America while other banks are fleeing with a tail between their legs; only the highest quality banks shine eminently during financial crisis such as the one we’re in.

The story doesn’t end here. One of TD’s prime online trading competitors, E-Trade Financial, may go bankrupt because it gobbled more home loans than its cash-flow permits. This is good news for TD, because should E-Trade files for bankruptcy, customers are only protected up to the first $100,000. Half their customers are over that limit according to Sinclair Stewart of Globe and Mail. For these clients, the sensible reaction is to lunge for a quick exit, and jostle to TD Ameritrade.

Another option is for TD Ameritrade to acquire E-Trade, a potential bargain now. I like how Derek DeCloet put it:

E*Trade’s fall is stunning. In 1999, at the peak of the Internet lunacy, it was (very) briefly worth more than the Bank of Montreal. Now it’s worth less than little Canadian Western Bank. Not five months ago, two hedge funds asked - no, demanded - Ed Clark to get out of the way and let TD Ameritrade, the Toronto-Dominion Bank’s partly-owned U.S. brokerage, merge with E*Trade. Since then, the latter has lost about $8-billion in market capitalization. Where are the hedge fund geniuses now? Awfully quiet.

E-Trade is still a prestigious brand. All Ed Clark has to do is spend a few bucks ($600 millions) to bulk up its presence in the discount brokerage space. It’ll be interesting to watch how the story unfolds.

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While feeling a little helpless during the recent market tailspin, it’s comforting to know that we can still count on many stocks to raise their dividends, as they always have been. My second anniversary as a dividend investor is coming up in Feburary, but boy, so far the reality is panning out just as all the dividend investing books said: scoop up rock-solid businesses with histories of raising dividends when they’re cheap. Pretty simple, really.

It’s time for another update on my portfolio. 2 months ago I reported a 22.7% distribution increase from North West Company income fund, however 4 more stocks have energized my passive income since:

Power Financial – 7.7% (25% from last year)
Telus – 20% (20% from last year)
Yellow Pages – 3.7% (9.7% from last year)
Boston Pizza Royalty Fund – 1.8% (5.5% from last year)

Pampered between a rent freeze and dividend increases, I can get used to this.

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Is it possible to buy an income trust with no money down and still own it free and clear in less than 7.5 years?

While browsing the Standard & Poors and DBRS rating pages looking for income trusts with strong stability ratings, I came across the power utility trust, Boralex Power Income Fund, which is rated SR-2(stable) and STA-2(low) respectively. You won’t find the typical income trust suspects. The fund doles out distribution using internal cash flow without eroding balance sheet (debt/equity = 0.30) or diluting share count. They own 10 power stations in Quebec and the state of New York:

• 7 hydroelectric power stations (51% of total output)
• 2 wood residue (33%)
• 1 natural gas-fired cogeneration plant (16%)

These power stations have amazing longevity with a couple dating back prior to the First World War. Furthermore, each station has power purchase agreements ranging anywhere between 20 and 40 years. As long as water continues to flow on rivers and population continues to grow, Boralex will continue to electrify investors’ bank accounts. Isn’t this a simple antidote in an investment landscape whipsawed by assets-backed commercial papers and recession chatters?

The strong stability does come with a handicap, however; the trust has virtually no growth prospect, which is why a cheap entry price is so paramount. The trust traditionally trades between $9 and $10, and despite hovering around $9 recently, the 10% yield was simply not up to snuff to justify the lackluster growth. Not being deterred, I shelved the trust onto my watch list just in case bargain surfaces.

Lo and behold, the trust has since been constantly banging at my door screaming, “new 52-week low!” Even the Financial Webrings forum is picking up on the story.

Not wanting to pass up a good opportunity, I raided half a position on Friday at $6.60. You ready for this? With its annual distribution at 90 cents, the trust is yielding a generous 13.64%! Not only that, most of the distribution is in the forms of return of capital and dividend, and with only a ninth in income, the distribution is practically tax-free. Even with no distribution increases, the trust’s compounded return will still eclipse the broader market. In case you’re curious, I mortgaged my water dams with a margin loan, but this is more lucrative than buying a Vancouver property with no money down. Just for fun, I calculated it’d take 7.5 years to wave farewell to the mortgage without forking a single dime. That’s assuming a marginal tax rate of 30%, and a tax-deductible 6.25% interests from Interactive Brokers.

So why is the trust being punished? The answer likely lies in the unfavourable hydrology in the 3rd quarter. Hydrology is fickle science. Due to unusually low water level, their hydroelectric segment generated 22.8% less than historical average, even though that’s only for one quarter. It was only a year ago when the water current was exceptionally strong, while year-to-date, the segment is down only 6%.

In my opinion, investors are unjustly extrapolating this poor quarter well into future return.

The water dams look the same, smell the same, sound the same, and feel the same as yesterday, a week ago, a month ago, 10 years ago and will likely remain the same decades into the future. The only difference is they’re 40% cheaper than the 52-week high. Moreover, these hydroelectric stations represent only half the eggs in the basket. The other half is humming along just fine; the 2 wood-residue thermal power stations and a natural gas-fired cogeneration plant have revenues steaming 7.5% and 20.0% higher respectively.

Having said that, there is no free lunch here. The production isn’t guaranteed, and we don’t know if the 2011 income trust tax ruling will choke cash flow. In my opinion though, as long as the trust is held outside of RRSP, the after-tax distribution shouldn’t change much, but I won’t go into the math here. Since power trusts are generally considered stable and boring, coupled with Boralex’s conservative balance sheet and high ratings from S&P and DBRS, I feel the distribution is safe, and the higher yield offers a margin of safety in a rare event of a distribution cut.

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Drooling over living off passive incomes one day?

Before plunging butt first into the sea of dividend-paying stocks, you must perform your due diligence. Get your hands on every conceivable dividend investing literatures: Dividend Growth, The Dividend Guy, Dividend Money, Dividends Matter and The Investment Zoo.

Then, you will need a few candidates to furnish your stock watch list. Not that these are all dirt cheap at the moment, but given the right entry points, these stocks will serve you well over the long-term to achieve your retirement goals.

1. IGM (3.40%) - The house always wins in casinos, and in the world of mutual funds, IGM is the house of King Kong. Every time a customer buys one of IGM’s array of equity investment products, he’s seemingly swindled anywhere between 2% to 3.5% in management fees. Much of these will eventually funneled to spoil IGM shareholders in the form of dividends. This is why I feel so guilty being an IGM investor. Can you blame me for yearning over this cash cow? The high yield coupled with the traditional dividend hikes in the teens make this one of the most formidable dividend payer in TSX.
2. Manulife (2.20%) - Another King Kong, but this time it’s in the life insurance space. Well managed by one of the most respected CEOs in Canada, Dominic D’Alessandro. Under his helm, Manulife doubled both its revenues and dividends over the past 4 fiscal years, thanks in parts to the brilliant John Hancock acquisition in 2003. The business has been so profitable, D’Alessandra accumulated over $10 Billions in the company vault to scout for other home run acquisitions. Manulife is not only big in Canada, but its operations are well diversified in the US and Asia, and currently penetrating the rapidly growing Chinese economy.
3. TD Bank (3.30%) - With the announced acquisition of New Jersey-based Commerce Bancorp, TD bank is now a true North American bank, according to CEO, Ed Clark. You have got to hand it to this guy for clutching his cash up until the last possible moment - when his Canadian bucks are near the all-time-high and US banks are in dire-straight. If I’m going to entrust my money to someone, that would be Ed Clark, who’s also genuinely composed enough to not succumb to U.S. subprime mortgages; unlike most other banks. The fact that TD sports the cheapest price/book among Canadian big backs and commands the biggest market share in online trading space give you reasons to buy and forget about it.
4. Canadian National Railway (1.60%) - One of the most diversified and efficient railroad business in North America. The CNR stock has been derailed recently by the rising Canadian dollar and ailing forestry sector, but this presents a buying opportunity for a long-term hold. Over the next many decades, CNR will continue to chug along as a big player in a space with strong economic moats. For one thing, it’s too expensive for new entrants to jostle into the railway networks. For another, oil prices will likely remain high, and that will set the stage for trains to surpass trucks as the most efficient mean of transportation. Of course, the fact that Canadian National Railway, Canadian Pacific Railway and legendary long-term investor, Warren Buffett, are all gobbling up other railway stocks is a hint that bargain hunting season had just begun.
5. Encana (1.10%) - When you invest in gas giant, Encana, you own oil and gas properties all over North America as mapped on their Corporate Profile page. This business is a money making machine who understands how to take care of shareholders. Over the past 5 fiscal years, Encana used its enormous cash flow to buy back about 22% of its own shares, while quadrupling its quarterly dividends from 5 to 20 cents. Furthermore, the recent latest record-breaking quarter has satiated Encana with $2.2 billion of free-cash-flow. If we annualize it, that’s $11.72 a share per year. Not bad for a stock trading at around $66.
6. Canadian Oil Sand (6.30%) - Canadian Oil Sand owns a 37% interest in the Syncrude project, a pure play in an oil sand that has stunning reserve life of 40+ years. Compared with the $95.93 oil, Canadian Oil Sand’s 2006 operating cost per barrel is dirt-cheap at $27.07, and it’s anticipated to mark down further due to economies of scale. So far this year, the operating cost per barrel has been $26.70. The trio of low operating costs, higher oil price and production positioned COS to raise quarterly distribution from 40 cents to 55 cents, or a cool 38%.
7. Teck Cominco (2.20%) - With Alcan being taken out, Teck Cominco is crowned as the only conglomerate mining company in Canada, and they only getting bigger with the recent acquisition of copper producer, AUR Resource. After losing a bid for nickel producer, Inco, to Brazil’s CVRD, Teck Cominco returned with a vengeance by adding copper, gold, coal and oil sand to its asset mix. Despite ponying up $4.1 billions for AUR Recourse, Teck Cominco’s balance sheet is still squeaky clean with $1.8 billion in cash. This figure is more than the $1.5 billion in long-term debt, so the company is effectively debt-free. Valuation wise, Tech Cominco is cheap according to an article by Andy Hoffman of The Globe and Mail. That’s because when broken into pieces, the individual segments are trading at lower multiples to their respective peers.
8. TransCanada (3.40%) - TransCanada is a diversified and stable utility company in an industry where all the pipelines in North America are already running at full capacity. The stock offers a safe play in the oil and gas sector without direct exposures to the underlying commodity prices. The yield is attractive, but I like it recently when it’s trading in the low $30’s. With 50 years experience and 59,000 km under its belt, TransCanada will add another 3,456 km through its Keystone project, due to complete in late 2009 or early 2010. This pipeline network will have the capacity to move 590,000 barrels of cruel oil per day from Alberta to US Mid West. It has already secured contracts to send 495,000 barrels per day with an average term of 18 years. If you’re looking for a pipeline investment with a little more yield and lesser growth, check out my post on How To Pick Pipeline Trusts.
9. Reitman (3.50%) - One of the tenets of dividend investing is to plunk your money down when good managements stumble. Fiscal 2008 hasn’t been gentle to apparel and accessories retailer, Reitmans. Unfavourable weather conditions and uninspiring rags from the Cassi experiment, a banner designed for middle aged women with youthful spirits, have torn the stock apart to a new 52-week low, thus pushing yield to a glittering 3.5%. Even though Reitmans stumbled on the recent catwalk, this debt-free retailer does have a long history of delivering superb return on equity and raising dividends. Number of outlets is expected to surpass 1,000 this year or next, and the company is poised to profit from the rising loonie. Opportune dividend investors will have a serious look to see if the valuation is compelling.
10. RioCan Investment Trust (5.9%) - You know what the real estate guys say. There are many uncertainties in the world, but there is one thing for sure. Land. They make them no more. With a few mouse clicks, you can instantly diversify your real estate holdings across Canada by investing in RioCan Investment Trust, which commands a quarter of the Canadian REIT index. RioCan, who owns 207 offices and shopping centres, has increased its annual distributions for 12 years straight. This company is known to be conservatively smart. CEO, Ed Sonshine, along with 4 other senior executives have been with the company since inception. In the first 5 years of this century, RioCan was quick to snap up undervalued properties with 9.3% CAP rate (this is unheard of in Vancouver, by the way). With real estate being high in the past few years, they sold off some non-core properties with CAP rate at around 6.3%.

Disclosure: Out of this list, I own IGM Financial, Canadian National Railway, Encana, Teck Cominco, TransCanada and Reitmans.

Disclaimer: I’m an amateur investor. If this post entertained you, I’ve achieved my goal. Please consult your financial advisor before making any investment decisions.