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The Discipline of Dividends- Heading North

(Guest Commentary by Rick Konrad – June 11, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will discuss his views on the Canadian economy and on specific Canadian Investment Trusts.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see "Only the Strong Survive” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

In our most recent post, we warned of the obsession that many investors seemed to demonstrate regarding risk aversion. As we said then:

“Risk aversion can be as dangerous to your financial health as risk taking. At least, it is at times of maximum risk aversion that the greatest opportunities exist to create wealth. Obviously, many investors are shirking from their riskier investments and selling in order to purchase what they deem to be safer. Hence, riskier assets demand higher risk premiums in order to be accorded attention. Ergo, higher returns for those willing to bear risk.”

One of the brokers I had met seemed absolutely frozen telling me that he had not recommended a stock in at least four years, and that he had expected an “L” shaped recovery. He expressed great concern about Europe, though apparently he had never owned a European stock and of course, Obama's “running the country into bankruptcy.”

For many people like him, a conclusion is simply the place where you got tired of thinking. Surely, other economies, other markets in the world may be doing just fine. Opening your eyes, doing a little bit of digging, and most importantly, some thinking will keep you from simply assuming the fetal position, rolling T-bills, and hoping for better.

Among the foreign markets that I am looking is my home (and native land) Canada. Here are a few of the reasons why:

  • Canada was the last of the G-7 countries to go into the “Great Recession”
  • Canada was the only G-7 country to go into the GR with a surplus
  • Despite its “socialist” image, Canada has advocated some major changes which demonstrate public/ private partnerships. For example, the Canada Pension Plan was formerly run much like the US Social Security …essentially, on an unfunded promise that involved imputed interest on non-existent imputed funding. There was no fund. It was merely a pay as you go system that worked well when many contributed and few received. Over the last decade, Canada has actually developed a sovereign wealth fund which at this point can fund about 30% of Canada Pension Plan needs.
  • Canada has one of the strongest banking systems in the world.
  • Canada has a bounty in resources.
  • Canada has relatively low corporate tax rates by OECD standards. Corporate tax rates are heading to 25% in Canada as compared to our 35%.
  • Just last week, Statistics Canada reported that GDP grew a startling 6.1 % in the first quarter of 2010. That was on top of its 4.9 % fourth-quarter growth--and well above the 3 percent managed by the US economy. The central bank, the Bank of Canada cranked up its lending rate from 0.25% to 0.50%.
  • What is fascinating about this growth is that it is occurring as government spending is slowing. Government spending was up 0.5% in the first quarter, down from the 1.6% pace of the fourth quarter, and the similar 1.7% increase of the third quarter. At a time when Europe is trying to strap on the afterburners and government spending here remains, to be kind, “stimulative,” the contrast is quite telling.

Unfortunately, Canadian stocks have not shown much of a head of steam despite this superior economic performance. When the world chooses to focus on Greece, Hungary, or perhaps Portugal or Spain, the focus is on US treasury bonds, not other national markets.

Many U.S. investors developed a bad taste for Canada back in 2006 when the Canadian finance minister announced the demise of Canadian investment trusts. These businesses operated much like REITS, not paying corporate taxes, but rather flowing through over 90% of cash flows as dividends to shareholders. As many investors held these securities in tax deferred or tax qualified accounts, the government's opportunity to collect cash taxes was also deferred to the distant future. When rumors of the largest Canadian corporate taxpayer potentially considering a conversion into this structure surfaced, the kibosh was quickly upon us.

The reform required these CITs to convert into regular tax-paying corporations by 2011. Consequently, payout ratios dropped and these businesses had four years to prepare.

Many years ago, when LBOs were under attack, Michael Jensen of the Harvard Business School suggested that much criticism was misplaced. In his testimony to the House Ways and Means Committee in 1989, Jensen identified “LBO associations” such as KKR and Forstmann Little as a valuable innovation in organizational form - a new model of management and governance that was competing directly with the headquarters of large public corporations, especially conglomerates. As he indicated, LBOs “substitute incentives provided by compensation and ownership plans for the direct monitoring and often centralized decision-making in the typical corporate bureaucracy.”

Dramatic concentrations of equity ownership appear to have produced large gains in operating efficiency. The heavy debt loads in these transactions, besides making possible the concentration of equity ownership, also perform an important control function, intensifying the search for efficiencies and discouraging reinvestment in low-return projects.

I suspect that the Canadian Investment Trusts that are now converting into regular tax -paying but high dividend payout companies are operating under a similar control function that intensifies the search for efficiencies. The constituency of shareholders that owns these companies expects a steady stream of hefty dividends if not a growing steam. This forces great concentration by management on developing and selecting decent cash producing businesses.

Here's a few such names.

AltaGas Income Trust (ATGFF) AltaGas is an integrated energy infrastructure and services business. Its activities include natural gas gathering and processing, extraction of ethane and natural gas liquids, transmission, wholesale sale of power from its gas-fired generation and power purchase-based arrangements, natural gas and natural gas liquids, rate regulated utilities, as well as retail energy services to commercial, industrial and institutional end-users across Canada.

AltaGas will convert into a regular Canadian corporation in July. The conversion is routine (and required under Canadian tax law) but the announcement of the new dividend rate was surprisingly generous.  Management stated it would continue to pay a monthly dividend, but at the reduced rate of CAD1.32 per share. That was 38.9 percent below what AltaGas has been paying as a trust since September 2008. However, it was also on the high side of the CAD1.10 to CAD1.40 per share range previously announced by management, and it still leaves a current yield approaching 8 percent.

The company is a unique blend of Western Canadian energy infrastructure businesses as well as becoming a major player in renewable energy, with 277 megawatts projected to begin operating in BC between 2014 and 2016.

Atlantic Power ( ATLIF  ) Atlantic Power Corporation, despite its Canadian listing,  owns indirect interests in 12 power plants in the U.S. Of the 12 plants, Atlantic Holdings has a 100% interest in two plants and interests ranging from 17% to 50% for the remaining 12 plants. The company also owns 72% of the transmission system rights in the Path 15 electric transmission project in California.

The company has completed its conversion into common shares as of late 2009. The conversion will not impact the historical CAD $1.09/unit distribution as the company has sufficient operating losses to shield meaningful cash taxes for some five years. Management has indicated that cash flow is sufficient to maintain the distribution into 2015.

It should also be noted that ATP is seeking to list on the NYSE in the second quarter of this year. At present, the yield is 8.9%.

Liquor Stores Income Fund ( LQSIF  ) Liquor Stores Income Fund is Canada's largest private retailer of alcohol, with over 225 locations: 170 in Alberta (~15% of the provincial total), 35 in British Columbia (~4-5% of the provincial total) as well as a handful of pubs. The trust also recently expanded into the U.S. by acquiring 19 locations in Alaska and 8 locations in Kentucky.

Liquor Stores brings a private enterprise culture to operating its retail stores. For example, convenience, and service are stressed with stores open 7 days a week until 2 am in some locations. LIQ typically offers two to three times the selection of its competitors. The major competitor in British Columbia is the provincial liquor control board store system. In Alberta, the system is entirely privatized but Liquor Stores is viewed as the prime consolidator of the industry.

Debt is about 18% of assets. Return on invested capital is about 8% but about 1.2 times the cost of capital. The current dividend yield is 10.9%.

Be careful! The trading in these names in the States can sometimes be somewhat thin. Nevertheless, I think for patient investors, these can be rewarding companies denominated in an appreciating or at worst stable currency. Dividends are subject to withholding tax of 15% which can be offset by the foreign tax credit.

Disclaimer: I, my family and clients own positions in all of the securities discussed in this post.

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