Survive the Credit Crunch by Sticking With Good Stocks
Stock-Markets / Credit Crunch Aug 11, 2007 - 08:30 AM GMTBy: Roger_Conrad
How do you solve a liquidity crisis? The simple answer is to inject more liquidity into the financial system. The hard part is not pouring in too much and thereby setting off a speculative boom in the markets that leads to a greater meltdown later on.
That's the dilemma facing the world's central bankers today, as the investment markets confront their worst crisis in half a decade. And unfortunately, the answer is no easier this time around than it was in the summer of 1998, the time of the last liquidity crisis.
That time around, the triumvirate of Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin and President Bill Clinton confronted the so-called "Asian Contagion" that had spread over a year and a half to engulf the entire world in a credit crunch. Their solution was to inject a huge amount of liquidity into the system to bail out the banks, and they used America's financial and diplomatic muscle to pull the rest of the world along.
The bailout restored calm to the financial markets. But it was later blamed for creating a climate of risk-taking that led to the bubble of 1999, which saw the Nasdaq Composite double and subsequently crash in the bear market of 2000-02.
Here in summer 2007, it's deja vu all over again. Like Greenspan/Rubin/Clinton, the current team of Ben Bernanke at the Fed, Hank Paulson at the Treasury and President Bush has said a lot about letting the market action run its course. Earlier this week, Bernanke kept the widely watched fed funds rate at 5.25 percent. And, doubtless reflecting the views of Mr. Paulson, the president stated his opposition to a bailout of the mortgage industry and support of letting things play out.
This Friday, however, they seem to be singing a slightly different tune. After a very bad Aug. 9 carried over into Aug. 10 in the world markets, the Fed swung into action and injected money into the system. That followed similar aggressive action by other central banks earlier in the week, including the European Union.
Where we go from here is anyone's guess. Encouragingly, central bank thinking appears to be pragmatic. On the other hand, this week's moves are also clearly reactive. And there's no guarantee what they do won't go far enough to really stabilize things or that it won't go too far and create another bubble.
Given the market's wild moves in the past few weeks, it's unlikely that volatility will die down immediately. Rather, we'll likely have more days of wild gyrations, at least until investors' apparently growing debt phobia subsides.
My basic message, however, remains the same as it was last week:
Stick with good, quality stocks. We're almost certainly going to see more volatility, but quality always comes back.
Some of the more extreme action this week came in the limited partnership (LP) area. LPs had been extremely hot this year, with new issues coming out in large numbers and existing LPs selling units at a rapid rate. LPs, however, aren't corporations but tax-advantaged entities that flow through pre-tax cash flows to investors, rather than post-tax earnings.
As a result, their balance sheets and income statements look different from corporations. And in a fear-driven market, that's apparently been enough to generate mass selling, no matter how stable the underlying businesses and assets are. ENTERPRISE PRODUCTS PARTNERS, for example, has traded anywhere from the $26 to $27 area to nearly $31 this week, despite announcing very steady second quarter numbers earlier.
Trading in ENERGY TRANSFER PARTNERS—which combines a very steady propane distribution franchise with pipelines and other basic energy infrastructure—was even wackier, moving from the low $40s to the mid-$50s. The LP, which a few weeks ago changed hands in the mid-$60s, has suffered the double whammy of being an LP and having a possible heavy fine levied by the Federal Energy Regulatory Commission for alleged market manipulation in the wake of hurricanes Katrina and Rita in 2005.
The total proposed fine of $167 million will likely be negotiated downward. Even if fully levied, however, it's unlikely to affect either the LP's torrid growth or distributions, which were boosted another 2.3 percent in June—the 14th consecutive quarterly increase.
Utilities are the ultimate safe stocks in any recession, simply because power, gas, communications and water service are always needed and demand is always growing. This time around, they're more disaster-proof than in many years, thanks to five-plus years of debt reduction and shedding operating risk.
Ironically, though they're still up for the year, utilities have been one of the worst hit groups in the marketplace during the past couple months. Even companies reporting extremely solid results have seen their stocks batted around, some on the same day they announce expectation-beating earnings.
DUKE ENERGY, for example, actually sold off briefly below $17 a share, its lowest level since the spinoff of SPECTRA ENERGY earlier this year. Second quarter earnings tore up the charts and came in a full 25 percent ahead of Wall Street estimates--almost unheard of for such a widely followed company.
Media coverage no doubt motivated some selling because it compared current tallies to what the company did last year when it held natural gas operations. But smart money soon took advantage of the weak hands to buy low, and the stock has since rebounded more than 15 percent.
The Duke example is instructive in this market because it clearly shows bargains can be had by opportunistic buyers not afraid to dive into fear. It's hardly unique, however.
Spinoff Spectra has also run in a very wide range this week. As with Duke, media spin painted the picture of a floundering company when it announced earnings this week.
But while headline earnings were down, the reasons were clearly ephemeral, including planned maintenance shutdowns in western Canada and the impact of a power outage. Meanwhile, the company continued to make progress on new projects that will lift future cash flows and earnings.
MAKING REAL MONEY
What's SOUTHWEST WATER worth? You'd have a hard time figuring that out from this week's market action.
The company, which provides regulated water service and manages municipal systems around the country, had a very strong second quarter, demonstrating that new management has turned things around.
The stock, however, opened the week at less than $13 a share, soared to well more than $16 and then backed off to the $14-to-$15-a-share range today.
That's truly extraordinary action for a stock that essentially confers ownership in such an ultra-steady business. As is the case for other utilities—from ATMOS ENERGY to XCEL ENERGY—it says absolutely nothing about the underlying company and its prospects to become more valuable over time.
What it does say is fear-driven markets are volatile creatures. When you're in one, even stocks represented by the most stable businesses imaginable are at risk of massive declines one day, followed by mighty rebounds the next.
Unfortunately, the only way to avoid the volatility is to sell everything and hole up in cash. And that's incidentally just about the worst possible thing you can do.
True, there are areas that are vulnerable on the fundamentals; mortgage companies come to mind. But if you've been buying quality companies all along, the best possible thing to do is just to ride it out. And that's particularly true if your holdings measured up in the now mostly passed second quarter earnings season.
If you're a trader, you can make a lot of money in this kind of market, provided you bet right. As a long-term value investor, however, I'm more interested in a much-higher percentage game: snapping up stocks of good companies when others panic sell them.
The key is to stick with what you know. We don't know what Bernanke/Paulson/Bush and their counterparts abroad are or aren't going to do to ensure global liquidity. We don't know how the markets will react to more scary news.
We do know there are businesses that are protected from global ups and downs. We do know there are real investment opportunities in the next few years. And, with earnings season now pretty much behind us, we also know which companies measured up on their second quarter results and which are on track to become more valuable year after year.
That's what we need to stick with in the coming weeks, adding to positions as opportunity arises. That's precisely what insiders of the better LPs did this week, including Energy Transfer Partners.
There are two investment opportunities I'm most sure of going forward the next few years. One is infrastructure.
The world is growing. And history shows clearly that even a full-scale liquidity crisis will only delay, not derail, the trend.
As the world grows, so is demand for infrastructure. Utilities—with their vast regulated cash flow streams—are the safest way to play the trend. As I've pointed out here numerous times in the past, good regulatory relations are needed to ensure a fair return on investment. In the US, that will increasingly concern spending on environmental safeguards, including likely control of carbon emissions.
Some companies will almost surely come up short and suffer the financial consequences. At this point, however, regulatory relations, even in traditionally tough states such as Nevada and Missouri, can only be described as constructive for utilities. And in the best parts of the country—such as the Southeast—utilities' environmental investments are actually starting to boost earnings, as SOUTHERN CO'S strong second quarter results indicate.
In effect, there's not a lot of fundamentals risk with utilities these days. That's a stark contrast with the top in 2000, when companies were levered up and heavily focused on riskier unregulated businesses.
The only utilities truly exposed to a liquidity crisis are those in the process of being taken over in leveraged buyouts, particularly from private capital. But private capital was already being shut out from buying utilities several months ago, as regulators and companies alike registered their opposition to such deals in advance.
In fact, there's only one company now truly at risk, TXU CORP. The company is still trying to complete its takeover by a consortium led by giant private capital concerns KOHLBERG KRAVIS ROBERTS and TPG CAPITAL (formerly Texas Pacific Group), at an offered price of
$69.25 a share. It dodged a regulatory bullet this spring, as the Texas legislature adjourned without imposing more restrictive rules on the deal—such as a formal review by Lone Star state regulators—or on the company's business and rates.
The hang-up now is whether the consortium will actually be able to borrow the $40 billion or so needed to finance the deal. Doubts have already taken a toll on TXU shares, which sank below $62 a share earlier today.
Undeniably, risk is lower now for those still holding TXU than it was when it was basically trading at the offer price a few weeks ago. And if the deal does go through, buyers will realize a quick 10 percent-plus gain from TXU's current price.
The likely downside risk if the offer is pulled entirely, however, could be as low as the upper $40s. That's still not a very good risk/reward picture in my book, particularly with Texas likely to clamp down at least somewhat on TXU's very high rates in the next couple years.
A better bet on a leveraged buyout going through is ALLTEL CORP, which was offered $71.50 a share by a consortium led by TPG CAPITAL and GOLDMAN SACHS. The shares currently trade in the mid-$60s, so completing the deal would add roughly 10 percent to shareholders'
pockets from these levels.
Unlike TXU, Alltel is worth considerably more than its offer price.
The company's rural wireless franchise is thriving and—as one of the few independents left—is increasingly attractive to the sector's big players.
Also, insiders are slated to get some $2 billion from cashing out, a fact that's already raised concerns that it wasn't constructed with other investors' best interests in mind. In other words, if the deal fails, the stock's not likely to fall by much; it's likely to wind up worth a lot more than $71.50 per share in cash.
Outside the utility industry, it's hard to go wrong with well-run LPs. As my colleague Elliott Gue writes in his weekly commentary, The Energy Letter ( http://www.energyletter.com ), concerns about LP debt are ridiculously overblown.
ENTERPRISE PRODUCTS PARTNERS, for example, has already raised the capital it needed to complete its massive asset build-out that will expand cash flows greatly in coming years, yet at one point this week, it yielded nearly 9 percent. It's now back to a more reasonable level but still nearly 15 percent off its highs.
Again, the key with all of these things is solid assets that produce reliable cash flows in all environments. Whether or not the authorities react too fast or too slow to the liquidity concerns, good infrastructure will continue to produce solid returns. That means it will be worth holding.
The second trend I'm sure about is energy. A full-blown liquidity crisis may slow demand for a while.
Even during the early '80s recession, demand for oil continued to rise in China. And today that country is a bigger driver of demand than ever. So is India, which was also virtually insignificant to global energy export markets in the '70s and '80s.
The bottom line is until we see the factors that ended the '70s bull market in energy, this one is going to keep going. One factor is conservation.
Then, it was a switch to small cars. This time, it's likely to be a move to hybrid vehicles or at least to cars that burn less gasoline.
But as anyone who's taken a road trip this summer knows, it's not happening yet on anything near the scale needed.
As for the second factor--a move to alternative energy--we've certainly seen some great moves in individual stocks such as AMERICAN SUPERCONDUCTOR CORP and VESTAS WIND SYSTEMS, as well as almost anything with the word “solar” in it. But there's nothing close to the magnitude of all those nuclear plants that came on line in the '70s and displaced most of the oil then used to generate electricity.
Factor three—new conventional oil and gas supplies—is also as far away as ever. That's best evidenced by our growing reliance on more-expensive, nonconventional energy sources such as Canada's oil sands and liquid natural gas, which at last count was providing an unprecedented 3 percent of North American gas supplies.
A full-blown liquidity crisis could set off a recession. But with inflation only a fraction of '70s levels, even that's unlikely to be the kind of demand destroyer the '80s recession was. And in any case, we're still a long way from a recession.
As long as the bull market in energy continues, it will always be a good strategy to buy energy stocks on dips. Conservative investors may want to stick with the Super Oils, such as CHEVRON CORP, which had blockbuster second quarter earnings. More intrepid investors will find a lot to like in the remaining independents, such as EOG RESOURCES, which are growing production and are takeover targets for the supers.
Finally, Canadian trusts' high cash flows and distributions—along with overblown concerns about 2011 taxation—make them particularly big potential winners when natural gas prices return to the upside.
Again, that could be delayed by a continuing liquidity crunch. But it's only a matter of time with demand growing, North American supplies shrinking and the country becoming ever-more dependent on liquefied natural gas, which is priced to volatile global markets.
As for everything else, it really boils down to getting under the hood with the companies you own. You wouldn't jump in a car and drive across the US in midsummer without making sure the engine is healthy or the brakes work, or examining the tires for wear and tear. Neither should you own stocks, bonds, preferred stocks or other securities of companies that you haven't checked out first.
It can be smart to hold some riskier fare, provided you understand what can go wrong. One area that looks increasingly interesting to me now is junk bonds.
For several years, many investors bought these for the higher yields, oblivious to the fact that they represented less-creditworthy companies. Now many of these same people are running screaming for the exits. Smart money, however, knows that low-rated debt isn't created equal.
For example, only a handful of regulated utility companies have ever filed for Chapter 11. And in every case, senior bondholders have ultimately been paid off in full.
Low-rated companies almost always regain their financial health, mainly because reliable cash flow from essential services can bail out even the worse management mistakes. In contrast, when companies in other industries default, bondholders are frequently wiped out.
Well-run, high-yield bond funds provide protection from defaults by spreading their risk widely. With credit spreads widening sharply now, they look increasingly like bargains.
No one, of course, should have all their assets in high-yield bonds any more than anyone should concentrate fully on LPs, utilities, Canadian trusts or any other one asset group. Rather, the idea is to focus on quality situations in a wide range of areas. That's the best way to navigate a tough market, as summer 2007 has become.
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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