November 21, 2006

8 Canadian Income Trusts: An Analysis of the Current Situation
         Peter Schiff, President and Chief Global Strategist

8 Water, Water, Everywhere??
        Two New Investment Recommendations

8 Global Investment Forecast
        Peter Cavelti, Guest Columnist

8 Peter Schiff's First Book
        "Crash-Proof: How to Profit From the Coming Economic Collapse"
       Buy at Pre-Publication Price!

8 Euro Pacific In The News

8 Upcoming Appearances

8 Previous Editions of Our Newsletter

Many of you have probably noticed significant declines in the prices of the Canadian Income Trusts lately, the majority of which are energy related. As this is likely causing some concern I wanted to explain what has happened and offer my recommendations for the future.

The decline began in late summer as oil and gas prices fell significantly from their highs. Oil dropped from nearly $80 per barrel to just under $60 while natural gas prices plunged from $14 per mmbtu to under $5. As a result the trusts corrected, creating what I believed at the time to be excellent buying opportunities in an ongoing energy bull market.

As of late October share prices rallied significantly, recovering more than half of their post-summer losses. Then on November 1, the Canadian Government surprisingly announced that it would end favorable tax treatment for trusts, thereby subjecting 100% of their earnings to Canadian taxes. (Up until that point only retained earnings were taxed, with distributions to unit holders counted as deductible expenses against taxable income.) As proposed, the new tax rules will go into effect immediately for new trusts, and will begin on January 1, 2011 for existing trusts.

Given that the recently elected conservative party had promised not to tax trusts, the move blind-sided investors and caused prices to gap down significantly when the news first hit. They have trended lower ever since. Most trusts are now down between 20% and 30% since the announcement, and many are now 50% or more below their 52 week highs!

While this is certainly a negative development, it is not the total disaster that many assume it to be. In the first place, we have four more years of tax free distributions. At current prices, yields are now close to 20%. At that rate, over the next four years the trusts will pay back close to 80% of their current share prices in dividends alone. Plus, if my forecast on oil and gas prices proves correct, we will likely receive dividend distributions in excess of the current share price during those four years. Furthermore, for the next four years the trusts will have a powerful extra incentive to increase both the distributions and the pay-out ratios, to take full advance of the current tax break.

When the higher taxes finally do kick in (if the proposal is not modified prior to the end of the four year grace period,) yields for taxable American investors will decline by 26.5% However, the reduced dividends will likely still be relatively attractive, especially if they had already increased to reflect higher oil and gas prices.

The most interesting aspect of this change is that after-tax distributions for tax- paying Canadian investors will not be reduced at all. This means that for such investors these trust are incredible bargains, and as a result are far better investments now than before the proposal was announced!

The reason for this is that under current Canadian tax law, trusts' distributions are taxed at ordinary tax rates of 46%. When the new proposal takes effect, those distributions will be taxed at the lower 20.5% rate imposed on corporate dividends. The net effect is a push. Therefore, the recent price drop represents a bonanza for taxable Canadian investors, who can snap up these trusts at fire-sale prices and enjoy after tax yields higher than they ever could have imagined under the current system.

The big losers of course are those average Canadians who own these trusts in their retirement accounts. They will have their dividends reduced by 31.5% and still be subject to ordinary income tax rates once those distributions are withdrawn from their retirement accounts.. Since most lack the additional private savings necessary to buy these trusts in their taxable accounts, they can not take advantage of the higher after-tax yields that today's low prices have produced.

As a result of the news, and wide-spread panic, Canadians and other foreign investors, are dumping their shares at prices well below what the actual present value of their diminished cash flows would dictate. However, once this panic selling ends, I expect that wealthy Canadians and institutions (as well as off-shore investors from low tax jurisdictions,) will accumulate all the cheap shares they can get their hands on. These moves will bid prices significantly higher as they top off their positions in a market where all the sellers have been washed out.

Ironically, the new tax treatment will result in a significant transfer of wealth and income from middle class Canadians to rich Canadians. I suppose viewed from that perspective, the politics of the move makes more sense. A lot of very rich Canadians are going to owe the Conservative government big time.

The best strategy for current owners is to wait out the initial panic, and perhaps look for a more opportune time to sell. I am confident that such an opportunity will present it self prior to the end of the four year grace period. In the mean time we will continue to collect the full distributions. Do not worry if the value of your account is down as a result of lower current prices. Remember, it is only a number, and as long as we do not sell, and prices recover, it means nothing. Once the small investors are completely flushed out, I expect that number to be far more reflective of the actual value of the underlying units. In addition, once the institutions are loaded up with these trusts, I anticipate lots of buy recommendations and other efforts designed to improve prices and goose performance.

A lot of Canadian institutional investors missed out on the big rally in oil and gas, as most of the trust units were purchased by mom and pop investors in their retirement accounts. When oil was $20 per barrel the consensus among the big players was that it was going to stay that way indefinitely. Even as it rallied to $50, most main stream analysts were suspect. Average Canadians did have the foresight, and it paid off. However, by changing the rules, the big guys can re-write history. With oil likely to remain in the $60 dollars per barrel range, they can now buy shares as if oil prices were still below $30 per barrel. Ironically it will be the Canadian fat cats that end up owning all the oil and gas reserves, even though they totally missed the initial move. The small retail investors who called it right end up losing. It just shows you that political connections can be far more important than accurate forecasting when it comes to achieving superior investment returns.

Again the reason I am so confident of a price rise, apart from what might happen anyway as a result of rising oil and gas prices, is that for Canadian taxpaying investors the after-tax appeal of these trusts has not been diminished. Therefore demand should be stronger than ever from those Canadians with the deepest pockets. The temptation to line them with these now significantly enhanced after tax yields should be too great to resist. In addition, these reduced prices make the trust excellent targets for foreign acquisition, particularly by the Chinese, who are anxious to diversify their stash of U.S. dollars into other assets, particularly oil and gas.

Many investors feel that water is becoming one of the most important natural resources in the world. With increasing global population growth, diminishing world wide supplies of water, and massive pollution, the pressures on the world's supply of this precious natural resource can only increase. We believe investors should consider having exposure to water resources as part on your portfolio.

As China and India rush into the modern world, they will consume increasingly large amounts of water, not just for drinking, but for commercial uses. The need for clean, unpolluted drinking water is obvious. What is less obvious, but just as important, is the huge need for water in industry, not just in Asia, but in every major industrial country.

We have selected two companies in the water industry that complement our overall philosophy to move wealth out of the US dollar and into strong equities in foreign currencies.

England's Highest Ranked Water Utility
Current Yield: 3.2%

Stock Price, 1/1/2002 - 10/31/2006

We have found England's premiere water utility. The performance of the companies' share price, as the above 5 year chart shows, indicates consistent, long term growth, with good and consistently rising dividends. Currently at 3.2%. In addition, we believe the U.K. Pound will continue to be a very strong currency. Year to date, it is up 10.4% against the U.S. Dollar. This is the kind of conservative, steady company that belongs in most portfolios as a core holding.

The company has been voted the UK Utility of the year for the second year in a row. The company provides high quality water and waste water services to more than 4.7 million customers and 140,000 businesses in the UK.Through its extensive waste water network and treatment facilities in the UK, the company ensures that the environmental impact of industrial waste is minimized.

The company is extremely well run and efficient. A recent report form the UK water regulator indicates that the firm is the most efficient in terms of operating and capital maintenance. The reductions in operating costs in recent years are the largest of all the UK's water and waste water companies.

Water Utility in Singapore

Stock Price, 1/1/2002 - 10/31/2006

This company is a Singapore-based water treatment company serving the Asian market. It originally serviced South East Asia and China, but has expanded to include India, Africa, and the Middle East. They can supply, build, and operate water systems for companies and municipal governments. 55% of their sales come from China, and total company revenues are derived 46% from the industrial sector and 54% from the municipal sector.

Their product line includes water desalinization, purification, reclamation, and recycling. Though mainly focused on the industrial and municipal markets, they have recently added a consumer line of filters and home filtration systems for the general public.

A growing company, their return on equity has average 24% over the last five years. Between 2003 and 2005 their net margin grew from 24% to 37%. They have assets of US$250m and their stock is part of the Straits Times Index, the Dow Jones average of Singapore. They have a slight yield of half of a percent.

Shares of the company saw an incredible run up from 2001 to mid-2005 rising 1600%. Their stock price is off 50% since then, as their expenses have increased. The company has expanded its payroll expense by 60%. This signals they are gearing up to handle future projects.

Recently, they received a US$205m contract to design, construct, and operate a seawater desalination plant in Algeria. Since May 2006, they have received contracts in China for water treatment plants worth over US$100m. Their backlog of orders increased in 2006 almost 200% to US$300M. The recent pullback in its share price offers an excellent opportunity to acquire this company at an attractive price.

Investing in foreign securities involves risks specific to international investing, such as currency and political risks. There can be no guarantees of success in pursuing any of the strategies we recommend, or that any of the specific companies will gain in value.

Peter Cavelti is one of the smartest investment and global geo-political thinkers we know. Swiss by birth, Peter has resided in Canada for many years, but has also lived in South Africa and the Far East. An acknowledged expert in gold, he is neither a "gold bug", nor a permanent gold bull. His firm, Cavelti & Associates Ltd., manages money and provides research for major global institutions. Not just on gold. But also on commodities, energy and global equities. He is an accomplished author, both in fiction and non-fiction, whose books have been internationally published.

We caught up with him recently, and asked for his current views on a wide ranging number of topics. Here is his latest thinking.

DOLLAR DECLINE

With the US in such a precarious debt situation, why is the dollar strong and gold weak? No one can predict when the seemingly inevitable decline in the US currency and US bonds will unfold. Yes, the dollar fundamentals are negative and the politically most convenient way to deal with the sharply growing US debt is to eventually pay it back in devalued dollars. For bonds, the longer term outlook may be even more troubling, as protracted military stresses and a deteriorating demographic profile adds to the fiscal imbalances already in place. That's why a potent hedge against your dollar and bond holdings, such as gold, should be a cardinal point in your investment strategy. Be careful, however, not to time a dollar and bond decline. The world in which we live is complex and analysts have already demonstrated how wrong they can be in predicting an end to the massive foreign capital inflows that have kept the dollar and bonds solid. But the correction will come: while Japan, China and oil producing nations keep sending surplus money to the US, an ever higher portion of the ownership of America's debt resides in foreign hands. That will eventually force a substantial dollar devaluation. In short: protecting against the coming correction in the dollar and bonds makes sense, but betting on that event to occur at a given time does not.

US BONDS

More cautious consumers will save more, which may help bonds in the short term. Let me caution you, though: I believe that any strength in the bond market will prove temporary. First of all, current bond yields reflect an expectation of only 1% GDP growth, yet the economy keeps growing at a considerably faster clip. That means that unless the US economy is headed for very low growth or even recession, bond yields could soon be driven higher again. I also don't like bonds from a longer term viewpoint. The structural impediments to fixed income markets are huge (see my comments in the previous segment), making a protracted bear market in bonds an almost certain long term bet. That's why I favor locking in high quality bonds with a life of up to five years and staying away from lower-rated issues and longer maturities.

US DEBT

A recent study by UBS elaborates on the US debt dilemma. In order to finance its current account deficit, America must attract $1.72 million of foreign capital every minute. At the moment, Japan is the largest holder of US Treasury debt with $640 billion, followed by China ($330 billion), Britain ($175 billion), and oil exporters Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the UAE, Algeria, Gabon, Libya and Nigeria. In looking at this list, I can't help notice that a significant number of America's creditors are nations that already are, or may soon be, on a collision course with the US. That's probably what led the author of the UBS study to conclude that "the days of cheap and reliable financing of the US consumption boom are coming to an end." Geopolitics, in particular, may upset the one-way flow of capital to the US.

GOLD

How low can gold prices fall? While sentiment is still negative and the yellow metal's technical position has eroded, fundamentals suggest that the current decline won't last much longer. The reason my previous comments on gold have sometimes been less than enthusiastic is that jewelry demand, a key factor, fell by nearly a third during the first half of this year. Why? Simply because gold prices were too high. Another thing that worried me: while jewelry demand sagged, gold kept being pushed up by producers (especially Barrick Gold), who bought back forward sales commitments. Most commentators praised such action, as I do-but they missed the fact that "de-hedging" by producers on such a large scale could not continue. So why do I think gold is now nearing an important bottom and will soon stage a meaningful rebound? First, because the metal has fallen sufficiently to give jewelry demand a fresh boost. Second, global mine output is falling. And third, the period of steadily rising interest rates appears over. Where do I think gold will bottom? Looking at the charts, the $550/580 range seems ideal for building a base. The Midas metals will take a while to consolidate at these levels, but I wouldn't be surprised to see the $650 area tested again by early next year.

NATURAL RESOURCES

The commodity bubble is about to burst! There is no thing as a commodity bubble! These are the two opposing views I hear from analysts these days. Which is right? A lot depends on how you define commodities as an asset class. If it contains only the hard raw material, you could say the "bubble" label is justified when it comes to some base metals, especially copper. But most analysts include stocks of commodity producers and exchange traded funds in their definition, and there I see no evidence of a bubble. On the contrary, most top-quality stocks of energy producers or miners trade at exceptionally low multiples, which in turn are based on reasonable commodity price assumptions. Also, the level of institutional investment in commodity based stocks is modest. For historical perspective, consider that in 1979, at their peak, natural resource producers made up roughly 25% of the S&P500; early this decade, at the cyclical bottom, the figure was about 5%; now it's 11%. So what's ailing commodity based investments? In a nutshell, the possibility that we may see a concurrent and meaningful slowdown of both America's and China's economy. To be sure, such an event could deflate raw materials prices and delay the resumption of their long-term upward trend. But the emphasis here is on delay, as opposed to discontinue. I firmly believe that we've only completed the first phase of a bull market in natural resources that will last another decade or longer. My advice: if your holdings of top-quality energy and mining stocks are below 20% of your total equity exposure, accumulate them on weakness.

ENERGY

What about the huge oil discovery in the Gulf of Mexico? My view is simple: a discovery that could nearly double current US oil reserves will be of immense benefit. But despite that, the overall context of US dependence on foreign oil will not change. US reserves amount to roughly 20 billion, the new discovery may yield 15 billion barrels, and annual US consumption stands at 7 billion barrels. Looking at the logistics of production, it will take at least three years before any of the new oil gets to consumers. And given that the discovery is situated in a notorious hurricane path, that target may be delayed. With the energy sector quite depressed, this may not be a bad time to position yourself.

A provocative and insightful examination of our difficult economic future and what investors can do to protect their wealth.

The economic tipping point for the United States is no longer theoretical. It is a reality today. The country has gone from the world’s largest creditor to its greatest debtor; the value of the dollar is sinking; domestic manufacturing is winding down–and these trends don’t seem to be slowing. Peter Schiff casts a sharp, clear-sighted eye on these factors and explains what the possible effects may be and how investors can protect themselves. For more than a decade, Schiff has not only observed the U.S. economy, but also helped his clients reposition their portfolios to reflect his outlook. What he sees is a nation facing an economic storm brought on by growing federal, personal, and corporate debt, too-little savings, a declining dollar, and lack of domestic manufacturing. Crash-Proof is an informed and informative warning of a looming period marked by sizeable tax hikes, loss of retirement benefits, double digit inflation, even–as happened recently in Argentina–the possible collapse of the middle class. However, Schiff does have a survival plan that can provide the protection that readers will need in the coming years.

Buy at Pre-Publication Price!

This Newsletter is a service of Euro Pacific Capital Inc.