Commodity And Vital Resource Producer Stocks are a Good Way to Protect Against Subprime Credit Crunch
Companies / Corporate Earnings Nov 11, 2007 - 01:31 AM GMTBy: Roger_Conrad
Earnings season is winding down. As always, not every company made its numbers. In fact, even in the essential service end of the market, there were some bad misses.
The news on SPRINT NEXTEL CORP, for example, continues to get worse and worse. Not only did the third quarter numbers show dramatic customer losses to AT&T and VERIZON COMMUNICATIONS, but the company has now abandoned its venture with CLEARWIRE CORP that was supposed to revive its floundering WiMax development efforts. That throws the future of the projected $5 billion investment in doubt. In response, the shares have tumbled again.
Happily, for the most part, earnings from the utility arena were mostly positive in the third quarter. That, plus the highly regulated and stable nature of their essential service businesses, has kept them steady over the past few months. In fact, we're still just a few percentage points from making new all-time highs in the major industry averages.
Utility stocks, however, are basically an island in what's becoming an increasingly fierce storm on Wall Street. As was the case earlier this year, the catalyst for the bad weather is the subprime lending crisis and the severe collateral damage caused on all manner of asset-backed securities and lender balance sheets.
Several months ago, I commented that, if things ever got really bad on the credit front, we'd find that money center banks were neck-deep in it. That's definitely proven to be the case here in late 2007, just as it was for every other financial crisis in memory from the Latin American meltdown of the early 1980s to the Asia Crisis and out-of-control corporate lending on tech in the late '90s.
The extent of the damage this time around wasn't readily apparent in second quarter earnings for financial stocks. But it's shown up with a vengeance in third quarter results, as bank after bank has written off literally billions in equity to reflect plunging investment values.
Even smaller regional banks well known for conservative practices have taken hits. For example, WACHOVIA revised its credit crunch losses up an additional $1.1 billion on Friday.
With the writeoffs coming fast and furious, a consensus has grown that this is only the tip of the iceberg, rather than the beginning of the end of a painful adjustment period. Rumors have grown that Barclays may take a $10 billion writeoff later this year, despite the bank's denials. And despite little evidence that sectors outside housing and related supply industries are slowing, many investors have become increasingly fearful that what lies next is a full-scale recession, here in the US as well as around the world.
The recession concerns are behind the dramatic slide in global equity markets. And their impact has been intensified by the spike in the price of oil toward the psychologically huge $100-per-barrel mark, as well as by the collapse in the US dollar exchange rate against almost every other major currency.
As longtime readers know, I'm bullish on oil for at least the next few years. The main reason is we're still not seeing the factors that ended the energy bull market of the '70s. That's meaningful, permanent demand destruction with conservation, a switch to real alternative energies not biofuels that consume nearly as much energy to make as they produce and a real find of conventional oil and gas reserves, as the North Sea discovery was to the '70s.
Until we see these factors in place, any pullback in oil prices will be only a temporary pause before a new move to higher highs. And with the public still expecting some magic wand to bring oil prices down painlessly, it looks like we're as far away from them as ever.
On the other hand, we've now seen a more than 40 percent jump in black gold in just a few months. True, inventories have tightened, political events are threatening existing sources of the fuel in several countries, and demand is still screaming ahead in the developing world especially. No market as large as oil, however, can keep rising indefinitely without a pause.
And unlike most commodities, oil is important enough to slow global growth on its own if its price rises too high too fast. i.e., sowing the seeds of its own decline. In the meantime, rising oil has exacerbated fears that growth will slow, and that's hurt stocks.
As for the US dollar, the Federal Reserve is really between a rock and a hard place. Based on what the central bank has said, it intends to continue cutting interest rates when it sees the need to keep growth going.
And it's shown a definite willingness to take dramatic action to avoid a recession. The federal funds futures rate is now discounting an 88 percent chance of yet another rate cut in the next few weeks, a decision that was practically telegraphed by Fed Chairman Ben Bernanke in comments this week.
The trouble is interest rate cuts are increasingly hitting the US dollar hard. That's because it reduces the greenback's investment value versus other currencies. Enough cuts in rates to head off a recession and eventually you have a lot more inflation, as rising foreign currency values import prices sky-high.
To a very large extent, it's the collapse in the US dollar that's triggered the mighty increase in the price of oil. Black gold is up in other currencies but not nearly to the extent it is here.
STILL GROWING
There's no magic number that will set off rapid inflation or a US recession. In fact, most employment and output statistics including what are considered leading and lagging indicators are still pointing to steady growth.
This week, unemployment insurance claims (UIC) came in well under expectations as well as prior levels. This is the most reliable reading of the employment picture because figures are never revised and they measure where the rubber hits the road--that is, actual people filing to collect real money for their unemployment. The fact that UICs are so low is a pretty good sign the employment market at least is still in good shape.
Another solid number to come out this week was productivity growth, which came in at more than twice prior levels and half again more than expectations. This is a complex number and, therefore, isn't as hard a number as UIC. But it's a very good sign for the long-term health of the US economy.
On the negative side are consumer confidence numbers, which, combined with mortgage market woes, may point to poor retail sales in the holiday season. But again, this is still more of a problem for sectors, rather than the full economy.
The upshot here is that market sentiment which is more and more strident that a recession is coming is still way out ahead of actual numbers that would indicate or even forecast one. With every selloff, more and more stocks are discounting not just a bad quarter or two but a real recession.
And that's particularly true of sectors considered the most vulnerable, such as the financials. But we're still not seeing the business numbers that would justify those kinds of stock market valuations.
In my view, the most likely thing to happen is the Fed will continue to tailor its monetary moves for the express purpose of avoiding anything more than a short-term slowdown in economic growth. That means anytime things start looking too grim, we'll see another rate cut. And unlike during the Greenspan era when monetary policy moved in slow increments Mr. Bernanke's half-point cut earlier this year is a pretty clear sign he's willing to move much more dramatically if he sees the need.
As long as this is the case, the odds of a full scale global meltdown will be low. As a former mentor of mine is fond of saying, you solve money crises with money. There will almost surely be rough spots along the way. But the deeper this market sinks into negative sentiment in the belief that there will be a major boondoggle, the less battered share prices will reflect basic business reality and the better bargains we'll find in high-quality stocks.
STRESS TEST
I'm by no means advocating abandoning all caution and backing up the truck on everything. But just as a receding tide or drought-stricken lake can reveal treasure beneath, so is the steady drop in investor sentiment on Wall Street.
There will almost certainly be more casualties in the coming months. And as the Sprint debacle demonstrates, they can occur in even what are otherwise the market's strongest sectors.
This is a stress test for companies. Some simply won't measure up to the combination of more restricted access to capital both from less aggressive banking practices and falling share prices and slower economic growth. Some will stumble as management makes the wrong move at the wrong time.
The good news is, however, we have a much better idea of who's hacking it and who isn't, now that most third quarter earnings are in. This week, investors sold off virtually every stock that reported. Even companies that came in with stellar results got only grudging support in a marketplace that seemed especially keen for any sign of weakness as an excuse to sell, sell, sell.
As I pointed out in a lecture this morning at the American Association of Individual Investors national conference in Orlando, this kind of sentiment is typical in markets like this. Rather than take good numbers for what they are an indication that business conditions are solid investors and analysts alike are hypersensitive to signs the numbers could worsen in coming months, particularly if bearish economic forecasts pan out.
It's not good enough for a company to report surging sales and make a strong forecast. Rather, that management guidance has to somehow be protected against where the consensus economic forecast has gone. And the more bearish that forecast, the higher the bar.
For long-term investors, there's a definite positive here. First, any of our stocks that do measure up to these exacting criteria are in very good shape indeed. It's always possible not every stone has been turned over and looked at under a microscope.
But you'll rarely find better odds that it has. No one is going to do this in a strong market, when the prevailing economic sentiment is “the sky's the limit.”
On the negative side, not even stocks that make it through the process are likely to gain much, if at all. In fact, they could be sold off, and sharply, if the market action around them is negative enough.
The only sure bets to gain ground during a market selloff are companies that receive high-premium takeover offers, preferably in cash. Metals and minerals giant RIO TINTO a portfolio pick in my new service Vital Resource Investor ( http://www.vitalresourceinvestor.com ) was the beneficiary of an offer this week. Rival BHP BILLITON made an offer that, though rejected by Rio Tinto management, still pushed the stock up more than 20 percent on Thursday, even as the overall market slid.
It's the nature of selloffs to wreak damage on almost everything. And those who don't take a long-term perspective more often than not wind up getting severely burned.
For example, I'll wager many of those who use set trading rules such as selling whenever something falls 20 percent are already getting whipsawed out of good positions. If they really operate as disciplined traders, they'll be able to use the stop effectively and eke out a few points by getting in at a lower price. If they're lucky, they'll get a tax break as well, as the rebound won't come until a month after they sell.
If they're like most of us, however, they'll spend a while looking at the just-sold position to ascertain whether selling was a good decision or not. If the price comes off, they'll pat themselves on the back and forget about it. If not, they'll obsess about whether they should get back in or not, missing distributions in the process.
The bottom line: They'll waste a lot of time and very likely money trying to overnuance a long-term position, rather than riding it up or down with the market's natural volatility.
Of course, if there's really growing weakness in the underlying business backing a dividend, you want to sell immediately. That's true whether a stock has recently doubled or has already been taken down 50 percent. Either way, odds are there are going to be more losses ahead, possible a lot of them.
As long as the underlying business is holding its own, however, there's every reason to hang in there with it. For one thing, the distribution will be continued and possibly increased. And as long as that's the case, recovery is inevitable.
HOW THEY RATE
Below, I've included a brief prognosis for the major income investment groups in the wake of this market mayhem. Note my overall strategy remains to hold top-quality picks for the long haul from all of these sectors.
UTILITIES Along with the highest-quality bonds, this has been the strongest income investment group during the selloff. The reason is they provide essential services that are always in demand, no matter what the economic outlook.
The industry has been strengthening now for five years. And investors still aren't much concerned with the capital challenge many face because they have to simultaneously expand and upgrade networks, cut pollution and get regulators to grant a return on investment.
My view is most don't really measure up. But I'm a great fan of Southern and Midwestern utilities that are aggressively involved in nuclear, wind and other carbon neutral generation, such as DOMINION RESOURCES, DUKE ENERGY and SOUTHERN CO.
US REITS This sector has started to get hit in earnest because of mounting concerns a US recession would further crater this country's commercial property market. As a result, even REITs reporting solid earnings, such as HOME PROPERTIES, have been taken out and shot and now sell for their lowest valuations in many months.
This kind of market action always gets my interest. And although I still believe Canadian REITs offer a better alternative because of higher yields, a much-stronger property market and the fact they're taxed as qualified dividends this is a group where bargains are starting to pop up.
As of yet, I'd stick to apartment REITs, which definitely have a counter-cyclical component because occupancy rates and rents can actually rise with the foreclosure rate as homebuyers become renters.
CANADIAN TRUSTS These were extremely volatile this week, ironic because earnings for high-quality fare were strong across the board. YELLOW PAGES INCOME FUND, for example, boosted distributable income per share nearly 10 percent in the third quarter, continuing a powerful string of results because of the successful integration of its print pages with the Internet. That trend may even accelerate with the trust's recent alliance with GOOGLE.
On the oil and gas production side, ARC ENERGY TRUST, ENERPLUS RESOURCES, PENN WEST ENERGY TRUST, PEYTO ENERGY TRUST, PROVIDENT ENERGY TRUST and VERMILION ENERGY TRUST which together comprise the best of the trust group also posted very solid results. All of them, however, actually weakened during the week on recession concerns.
This group has had a great 12 months since last November, when the Canadian finance minister announced trusts would be taxed as corporations beginning in 2011. A lot of that has been due to the 20 percent jump in the Canadian dollar versus the US dollar.
But it's also becoming clear that trusts backed by good businesses are in great shape to keep paying big distributions well beyond 2011, no matter how they're taxed. And on a book value basis, they're among the cheapest investments in the world.
The going could stay volatile for a while. But the positives that have gained ground over the past year are set to accelerate. And as long as that's the case, this remains a great group to hold.
BONDS AND PREFERRED STOCKS Keep it simple; keep it safe. There's absolutely no reason to venture out on the long-term end of the bond maturity spectrum unless you want to speculate on interest rate swings after they've already declined substantially from their summer highs. Rather, keep the maturities in the five-to-seven-year range.
Also, it's better to buy mid-grade bonds than high grade but only if you're sure about the prospects of the underlying companies. Utilities are ideal because of their nearly perfect record of recovering financial strength after any debacle. CMS ENERGY is a favorite.
In the preferred stock space, there are no real maturities. But focusing on weaker but strengthening fare is an even more effective way to control interest rate risk.
That's particularly true now in view of the overemphasis investors have attached to risk, even for companies that have proven themselves in terms of growth and are still putting up powerful numbers. The drop in Comcast Corp's preferred stocks is a particularly egregious example that's given investors another golden opportunity to lock away a high yield cheap.
FINANCIALS This is ground zero for this market. The writedowns have spooked investors and triggered massive selling across the board, even for stocks that have thus far controlled exposure to credit concerns. REGIONS FINANCIAL, for example, posted a 12 percent third quarter profit gain and took the highly conservative step of increasing its reserve for losses. Its shares, however, have plunged since.
It's hardly the only example in the industry either; the group has been once again dragged through the mud by the prior mistakes of its leaders. I don't believe anyone in search of building a balanced portfolio should completely eschew any group, no matter how dire things may look. And I don't think anyone should abandon positions here, unless there's a real risk of significant further deterioration.
That would apply to mortgage specialists but little else. Meanwhile, conditions are building for a strong recovery.
CLOSED-END BOND FUNDS These also continue to get beaten up as investors worry about holdings and push them to ever-deeper discounts. Again, the key to all of these funds' ultimate sustainability and distributions is what's inside, not how the public views it.
Those who have an inordinate amount of their portfolio in these may want to lighten up. But if these are just one segment of your overall income portfolio, there's no need to abandon hope at these prices. Rather, think of selling when they trade at big premiums to net asset value, which will happen when sentiment inevitably swings and investors bid them up once more.
SUPER OILS The market's ardor for the Supers waned considerably after they reported weaker-than-expected earnings on a slump in the refining business. Refining lagged because the price of their primary input oil spiked toward $100 a barrel.
Meanwhile, the prices of their primary products gasoline, motor oil, etc. went up far less. The result was squeezed margins and lower profits overall for the Supers.
The good news here is actually bad news for us consumers: Prices of refined products are going higher; that will restore Supers' margins, even as they cash in on higher oil prices.
If these stocks do have an ultimate worry, it's resource nationalism, which is making it more difficult for them to boost production. The best positioned is CHEVRON CORP, which has a number of exciting discoveries in less-exposed regions. In any case, this group was solid at $20-per-barrel oil and will be in almost any economic scenario.
FOREIGN UTILITIES This has been a good group to own for three reasons. First, as utilities, they weather any environment and are taking advantage of growing global growth, which is boosting demand. Second, they're in the midst of a consolidation wave that's driving up share prices. Third, they're benefiting from the ongoing drop in the US dollar.
Stick to the safest, such as Italy's ENEL. The company was maligned in the “Wall Street Journal” this week in an article that implied it was overleveraging its future to Russian growth.
In reality, that's a balanced investment for a company that now owns extensive assets in Europe and Latin America, by virtue of its recent takeover of Spain's ENDESA this year. The Endesa buy wasn't mentioned anywhere in the article, whether on purpose or because of lazy journalism. In either case, it points to an underappreciated company.
COMPLEX INVESTMENTS I've lumped together several income investment types into this group to illustrate their common plight: All have been sold off because of inflated fears about how “complex” their balance sheets and business are. Affected groups include rural telecoms and limited partnerships (LP).
Rural telecoms rarely earn their distributions, instead paying them out from free cash flow augmented by tax dodges. LPs pass through substantially all their income in dividends without taxation and, therefore, often have higher debt leverage than corporations.
Neither option can be adequately evaluated on the basis of standard earnings-per-share measurements. But many investors try precisely to shove their square shapes into round holes and come away with an extreme misperception of their actual risk.
Not all are bargains. But this is the kind of group where the good get lumped in with the bad and ugly.
VITAL RESOURCES In the past several issues of Utility & Income, I've advanced the idea that buying commodity and vital resource producer stocks is a good way to protect yourself against events that can hit most other income investments. In my view, the most likely of these is a revival of inflation at some point from the Fed's zealous efforts to pump up the economy.
In the meantime, however, these are doing very well simply from the strong global economic growth that requires vital resources in ever-greater quantities. Vital resources can take a real licking when recession worries surface. That, in my mind, makes now a good time to get some exposure, if you haven't already.
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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