Stock Market Investments - Hanging In There
Companies / Corporate Earnings Jul 28, 2007 - 12:39 AM GMTBy: Roger_Conrad
I'm a glass-half-full guy. I always look for the bright side. And when things look their blackest, my every instinct is to buy, buy, buy.
I've also been in the investment business long enough to know that things don't always work out. Many times, where's there's smoke, there's a raging blaze that will scorch anyone who gets too close.
Businesses as cash-rich as investing do attract criminals. And you can't always trust the numbers.
My goal as an investment advisor is always “buy smart, buy safe.”
Doing that effectively means the bullishly inclined advisors like me have to keep the bears' arguments firmly in mind. You may not want to believe or even hear their point of view. But in this business a healthy dose of skepticism is often worth several tons of cure, the price of ignoring a key risk.
My colleague Ivan Martchev ( http://www.attheselevels.com , http://www.globalviewpoints.com ), who I featured this spring for his views on exchange traded funds, is best known as the leading skeptic in our shop. I haven't always agreed with his conclusions over the years, but his insights are always worth a look.
An area that he's commented on several times over the past year is cited as one of the primary reasons for recent weeks' stock market volatility: the unfolding credit crisis in the subprime loan sector.
Bluntly speaking, these are basically loans made by banks and other financial companies to people who didn't have the credit standing to get regular loans. In the midst of the property boom, many people took out such loans to buy houses that would otherwise have been well out of their price ranges. The lenders, in turn, were able to show robust sales and earnings from runaway loan growth.
Unfortunately, the interest rates on these loans were pegged to volatile financial instruments. When rates rose earlier this year, the most leveraged became unable to keep up with payments.
Meanwhile, home prices fell, wiping out equity and leaving the most leveraged actually owing more than their residence was worth.
Lenders eventually became unable to continue their forbearance, and the result is a surging rate of defaults.
At first, the problem in the corporate world seemed confined to a handful of aggressive lenders. But with BEAR STEARNS running into trouble this spring, it became obvious that financial houses that packaged and sold the loans were also at risk.
This week, we got more indications that the damage may get worse.
Mortgage company COUNTRYWIDE FINANCIAL -- which does a lot of other things besides subprime lending--reported a massive $710 million hit to its second quarter earnings from bad credit. Worse, CEO Angelo Mozilo forecast the mortgage lending and housing industries will weaken further in the second half of 2007 and no recovery in the nation's housing market until 2009.
That forecast was further reinforced by the housing industry numbers that were announced Wednesday and Thursday, setting off a massive selloff in the stock market. Mainly, sales of single-family homes plunged at an annual rate of 30 percent in the second quarter, the steepest decline in 28 years. Supply of unsold homes remained at a 15-year high. And the weakness was national: According to National Association of Realtors data, June sales fell 7.3 percent in the Northeast, 6.8 percent in the West and a less pronounced 2.8 percent in the Midwest and 1.7 percent in the South.
Admittedly, I say this with the benefit of 20-20 hindsight. But a weaker housing market was somewhat to be expected, given the incredible strength in this sector in recent years. And there are some markets--particularly areas close to prosperous urban centers--where fallout has been relatively mild, or even nonexistent. The unanswered question, however, is how the combination of a damaged mortgage market and weak housing conditions will impact the overall economy and, by extension, the US and global stock markets.
Every major financial crisis this century has peaked with the major money-center banks really getting whacked. Each time, they stepped squarely into whatever mess was emerging. They managed to hide the damage for a while before succumbing. Finally, the Federal Reserve has stepped in to save them, drawing criticism but ultimately settling the market.
It's still far too early to tell if the subprime lending fiasco will really mushroom into something of that magnitude. But if it does, my bet is on the money-center banks to crack again, BANK OF AMERICA'S 14 percent dividend increase this week notwithstanding. That's one reason to be wary of them now.
Financial stocks are a major part of the stock market averages. A crack in that sector (particularly the money-center banks) would almost certainly have a huge impact on everything else. And real weakness in the banks also has ramifications for the overall economy, given the possible impact on borrowing costs and liquidity.
It's inconceivable that monetary authorities would do anything else but act to support the system if things got too bad. But in view of this unfolding risk, it is a good time to take a look at the major income investment groups, and how they are or are not protected.
HIGH-QUALITY BONDS: These are a traditional haven when credit is a concern. Earlier this summer, the benchmark 10-year Treasury note yield broke decisively past 5 percent and showed every sign of continuing to rise to the 5.5 percent range. Over the past two weeks, however, the yield has broken well under 5 percent, as institutions have tried to beef up their “safe” positions. The worse this gets, the lower the benchmark is likely to go, and the better high-quality bond funds should perform. VANGUARD GNMA (VFIIX) and VANGUARD INTERMEDIATE-TERM CORPORATE (VFICX) are two high-quality bond funds with low duration (read: exposure to interest rate volatility) that should benefit. Both pay competitive yields of more than 5 percent, largely thanks to very low fund expenses.
UTILITY STOCKS: These held up well during the 1997-98 Asian Financial Crisis but not so well in the downturn that followed the September 11, 2001 terrorist strikes on New York and Washington. In view of the industry's far more solid financial situation now, I expect their performance during a downturn to be far closer to their 1998 showing.
In the power sector, there are some concerns about upcoming capital spending needs, and state regulators' willingness to grant a fair return on investment. The apparent settlement of a rate dispute in Illinois involving units of EXELON and AMEREN resolves worries involving that state.
Moreover, most states remain firmly committed to fair returns as the price of improving system reliability and meeting likely mandates to control carbon emissions. As a result, particularly given the strong second quarter earnings that appear to be coming in around the industry, this should not affect utilities' ability to hold their own in a downturn.
It's worth noting, however, that a number of stocks have been pushed up to very high levels on speculation of a private capital takeover.
With BABCOCK & BROWN abandoning its quest to take over NORTHWESTERN CORP this week, a wave of this kind of takeover looks increasingly unlikely. In fact, the TXU CORP takeover by a KOHLBERG KRAVIS ROBERTS-led consortium is also attracting increasing opposition.
As a result, stocks bid up on private equity takeover speculation are likely to lose value from here. Note, however, that private capital may be replaced by foreign utility buyers, as a number of companies have expressed interest in using their sharply appreciated euros to buy US utilities. IBERDROLA'S takeover of ENERGYEAST is unlikely to be the last such deal.
In short, the best idea is to continue to hold high-quality utilities, and buy more when prices come off. Should the 10-year yield continue to fall, they're going to, at the very least, have a lot of downside support.
REITS: Real estate investment trusts are obviously at risk to a decline in the property market. And after an almost uninterrupted rally since 2000, there's still considerable downside despite recent declines.
Valuations for many commercial US REITs are frankly off the chart.
The exception to the rule remains apartment REITs, which are still sharply undervalued after lagging for many years due to increased home buying on low mortgage rates. There's also a case to be made why apartment REITs may benefit from mortgage loan defaults, as those bereft of their own homes will have little choice but to rent.
MID-AMERICA APARTMENT remains my favorite in the group.
Investors should also take a hard look at Canadian REITs. These yield 2 to 4 percentage points above their US peers. The Canadian property market is still on very firm ground, particularly in Alberta where oil sands development continues apace. Canadian REITs also tend to have higher occupancy rates and more conservative balance sheets than their US peers, and they've been takeover targets besides. My favorite is the country's biggest and strongest, RioCan REIT.
CANADIAN TRUSTS: These continue to get a bad rap with some investors, despite the fact that the indexes have rallied close to pre-Halloween 2006 levels. On October 31 of last year the Conservative Party government announced a plan to tax them as corporation in 2011. Most likely, that plan will now only be overturned if the Conservatives' chief rival--the Liberal Party--wins the elections likely to be held sometime in the next 12 months.
For the best-run trusts, that hardly matters. They'll either be taken over long before then, very likely by private capital at a generous premium to current prices. Or, they'll find a way to dodge the bulk of the taxes, given the average Canadian corporation pays just 6.7 percent of income versus the 31.5 percent official rate.
Or, they'll simply outgrow their future burden. Meanwhile, they'll continue to pay what are literally the highest yields in the world.
And management after management has stated it will continue to pay high yields no matter how they're taxed in 2011 and beyond.
Even if the Conservative Party stays in power and the trust tax endures, the prospective burden was baked in during last November's selloff. It's done as far as a danger to trusts' share prices. That means if the rules change, it's all upside for trust shareholders.
And if they don't, we'll be no worse for wear.
As for exposure to a financial crisis, trusts really break down into two groups. The more popular energy producing trusts are by far the more vulnerable, for the same reason that all energy stocks are. An economic crack is one of the very few things that can stall this energy bull market.
Should one occur, it still would have only a temporary impact on the real driver of higher oil and gas prices: Tight global supplies and the shift of market power to producers from consumers, who held sway during the 1990s. But it could knock down oil and particularly gas, which remains largely a domestic market.
I've always advised sticking to the strongest in this group, those that have deep pockets, long-lived reserves and generally low costs, such as ENERPLUS RESOURCES. But the most interesting group as a crisis hedge is the trusts that aren't involved with energy production, particularly electric power and pipeline trusts such as PEMBINA PIPELINE INCOME FUND. Pembina has the exclusive franchise for transporting the output of the SYNCRUDE partnership, the leading player in Canada's oil sands.
SUPER OILS: Even if energy prices do weaken temporarily, the world's Super Oils will remain one of the safest havens around. With balance sheets stronger than most world governments and unmatched reach, these companies can literally weather any storm, and come out stronger than ever. CHEVRON, with its rising production profile, is the best of the bunch.
REGIONAL BANKS: This is where things get really interesting. On the one hand, they can't help but be exposed to turbulence in the property market in the regions they service. On the other hand, they're almost always very conservatively positioned, and certainly far more so than the money center banks. My favorite in the group for several years has been REGIONS FINANCIAL, which is centered in the nation's most solid region, the Southeast. In a timely move, the company disposed of its subprime mortgage unit in a sale to BARCLAYS BANK earlier this year. Yet its shares have been weak along with the rest of the sector. The MORGAN KEEGAN unit would be exposed if the stock market weakened. But at this price and a yield of around 4.5 percent, downside looks limited.
This isn't a comprehensive list of income investments. Closed-end bond funds could prove to be another strong haven, though a lot will depend on what they own.
ING PRIME RATE TRUST, for example, has been taking quite a beating over subprime concerns, though its distribution has remained constant and rising rates are generally a good thing for the securities it holds.
High-yield bonds could wind up being very much at risk in this thing, including mutual funds that own a lot of them. Credit spreads had been narrowing sharply to relatively low levels, but they've now started to widen in earnest.
Unfortunately, there's not a lot one can do if they're invested in a mutual fund holding what are colloquially known as junk-rated debt.
No matter how well a fund is managed, how diversified or how well it's controlled the risk to its distribution, the value of its holdings will drop as credit spreads widen. In fact, that will happen no matter how solid the issuers of its holdings are.
That's what appears to be happening to ING Prime Rate, which holds a broadly diversified portfolio of more than 500 senior debt securities issued by companies rated less than investment grade. The securities' yields adjust upward when interest rates rise, protecting the fund's value.
ING's net asset value has thus far held up well. But its market price has been hit hard, sending it from a modest premium to a steep discount to net asset value. Investors appear to be simultaneously worried about the heightened risk of default from its securities, the impact of widening credit spreads and quite possibly that falling interest rates will push down the distribution. Throw in the fact that the fund's very name includes the word “prime”--and that many income investors fearfully sell anything that drops--and it's easy to see why the fund has crashed of late.
Those who still hold can take solace in the fact that the fund's basic quality is solid and that it's now extremely cheap, selling for barely 92 cents on the dollar. Also, ING Prime Rate's fate has been mirrored by weak performance in other high-yield-oriented debt, and when the market turns it will head back quickly to its old highs.
Nonetheless, as long as the market remains concerned about sub-prime mortgages, housing and credit spreads--ING Prime Rate and others may still have downside left. A less volatile way to play a reversal is with an open-end fund.
As for buying individual junk bonds, the key is wise selection.
Utilities with low ratings have always been able to repair finances by focusing on their utility business, cutting costs and debt and working with regulators. They're far less risky in a deteriorating environment than an industrial or retail company that has far less reliable cash flows. They may take a hit in sympathy with the broad high-yield market, even if the underlying issuer is near a credit rating boost. But any dip in prices will be a buying opportunity.
The bottom line is underlying businesses. As long as the companies backing the securities you own are strong and growing, your portfolio will weather whatever comes down the pike, be it a subprime mortgage crisis or something else entirely.
The key is assessing what you own now, when the future is uncertain and before we've seen any real damage. This whole thing may blow away, and as an optimist that's pretty much what I expect to happen.
But you can bet I'm taking a hard look now at everything I own and how my companies are stacking up as businesses.
If something does happen, I want to be sure of what I'm holding. And there's no better time to do that than right now, as second quarter earnings season kicks into gear.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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