Utility Stocks, REITs, Canadian Trusts, Carbon Regulation, Interest Rate Outlook, Enerplus Resources & ETFs
Companies / US Utilities May 18, 2007 - 08:23 PMBy: Roger_Conrad
QUESTIONS & ANSWERS : Greetings from the Las Vegas Money Show conference. For attendees, investment seminars are always a golden opportunity to learn a range of perspectives. At the same time, it gives advisors like me a chance to better know readers' concerns and interests so we can do our job better.
In addition to several other events, I gave three presentations in Vegas on Canadian trusts, utility stocks and the likely beneficiaries of almost certain carbon regulation. Here's a sampling of the questions I received during my own presentations at the show, along with my answers.
Q. GIVEN THEIR EXPLOSIVE RUN OF THE PAST SEVERAL YEARS, DO UTILITY STOCKS HAVE MORE UPSIDE LEFT?
A. Some have likely run out of gas, but others still present compelling, long-term values. The key question going forward is going to be capital spending. The sector has had a major investment deficit for more than three decades, dating back to the 1970s when rising costs began to convince regulators to deny returns on investment in the name of lower customer rates.
That ended the regulatory compact that existed in the '50s and '60s and allowed companies to really build out the US system. Now we're starting to see a major revving up of spending on a range of issues, particularly environmental ones.
In the '50s and '60s, greater capital spending always flowed through to the bottom line as regulators routinely allowed a fair return.
That didn't happen in the '70s, '80s and '90s. But since the demise of deregulation, officials in most parts of the country at least have been allowing decent returns.
Most states—as well as the federal government through the Federal Energy Regulatory Commission—have come to the conclusion that a fair return is essential to meeting the investment needs of the sector.
As a result, utilities are getting compensated for things such as environmental cleanup, transmission investment and other matters, in addition to recovering things like fuel costs.
As long as that continues, higher levels of capital spending will mean rising earnings for utilities. The trick will come later on, after much of the new investment is passed into rates that are likely to be somewhat higher.
At that point, regulators may change their mind and revert back to the mentality of past decades. That will no doubt kill off further capital spending for utilities. But it will also be very bad news for shareholders of utilities.
Consequently, monitoring the mood of regulators will be increasingly important in coming years. The simple truth is companies that get along with the officials who oversee their rates will enjoy rising earnings, dividends and share prices in coming years. Those who run afoul are going to be hurt, possibly very badly.
Q. WHAT REAL ESTATE INVESTMENT TRUSTS (REITS) DO YOU RECOMMEND?
A. I like the apartment REITs and some of the Canadians but little else in the sector. We've had a more than seven-year run in these things that's taken the average yield down somewhere under 3 percent. The whole thing seems to have become a game for institutions and momentum players, and in my view, there's little appeal for the long-term investor.
The apartment REITs are different because they were largely left out of the rally starting in 2003, when the Federal Reserve began to really cut interest rates. Would-be renters decided to take out a mortgage rather than continue to pay their landlords. As a result, rents lagged, and residential and apartment REITs did as well.
Now it's the group's turn to shine as more people rent and the residential REITs are thriving. They're also yielding 4 percent to 5 percent on average, well above other REITs.
As for the Canadians, the country's economy continues to thrive in this commodity boom and REITs of all stripes along with it. And you can still find yields of 5 percent and higher across a range of properties there, too. Those are values we haven't seen in this country for some time.
Canadian REITs are also exempt from the prospective tax on income trusts that's now slated to begin in 2011.
Q. HOW CAN WE TRUST THE CANADIAN GOVERNMENT NOT TO CHANGE THE RULES AGAIN ON INCOME TRUSTS FOR THE WORSE?
A. The better question is how can you really trust any government to have a consistent line on any issue over time, particularly when it comes to taxation. The good news is we have a great deal of assurance that the worst is in here.
For one thing, the Canadian government has already accomplished its goal of eliminating the trust sector growth by effectively preventing any new conversions. The remaining trusts' growth is also limited by the restrictions on the number of shares they can issue--basically no more than 100 percent before 2011.
Another reason a further tightening of rules is unlikely is the trusts have also been pushing back on this issue, and public opinion has moved against the government. The fact that Finance Minister Jim Flaherty is effectively trying to sneak the legislation into larger bills is clear evidence of that.
Based on conversations I had at the conference with executives of ADVANTAGE ENERGY INCOME FUND, ENERPLUS RESOURCES and PENGROWTH ENERGY TRUST, no one is expecting the trust tax to be overturned completely and certainly no one is betting on it. Rather, the key going forward is how well businesses are run and, in the case of oil and gas producers like these, what happens to energy prices.
For investors, the bottom line is the worst-case scenario on taxation is in the trusts' prices. There's still a possibility of the Canadian trust tax legislation being changed favorably at some point in the future, particularly with the Liberal Party suggesting such a course. But the best trusts aren't basing their business plans around such a possibility, and neither should we investors.
Q. THE CAP-AND-TRADE SYSTEM TO CONTROL GREENHOUSE GAS EMISSIONS SEEMS TO MAKE NO SENSE. ISN'T THE WHOLE THING A HOAX?
A. There are many people who still dispute the idea that carbon dioxide (CO2) emissions have any meaningful impact on the world's climate. And there are probably even more who see attempts to control those emissions as absurd.
On the other hand, there aren't very many of them outside the US and virtually all globally respected scientific organizations have accepted the basic premise that CO2 regulation is needed.
I don't presume to have the scientific knowledge to say unequivocally who's right and who's wrong. What I do know is carbon regulation in the US is now almost certain.
The speculation is that we'll see legislation pass the US House of Representatives sometime this fall, at which point it will become a powerful cudgel in the 2008 election. The president has said over and over that he'll veto anything he deems too severe. But his popularity and political clout is lower than even President Nixon's was in the last days before he resigned. Unless he stages a rapid comeback, no one's going to listen to him next year—even on the Republican side—when legislation comes to a vote.
When the momentum is going this strong in one direction, investors need to take notice. As is the case with all utility capital spending, the key on this issue is whether regulators will allow them to recoup the costs they incur.
Cap-and-trade would definitely make this easier because it allows companies flexibility to comply with new regulations in their own way. It would work by first capping the amount of CO2 emissions economywide. In order to exceed those targets, companies can either make investments to do so or buy credits to pollute--therefore buying more time for technology to develop to solve the problem.
Cap-and-trade has been ridiculed by some people for some of the more outrageous manifestations. What doesn't get appreciated is cap-and-trade has actually worked very well in the past with regard to tackling environmental problems. The best example is the Clean Air Act of 1990, which was signed into law by the first President Bush.
At the time the bill passed, a lot of people thought it would either bankrupt companies or be entirely ineffective reducing the emissions that caused acid rain. As it turned out, neither happened. Companies have had time to make adjustments, and sulphur and nitrogen oxide emissions are no longer a major problem in many areas. Sure, there were problems, but cap-and-trade did what it was supposed to.
The other reason cap-and-trade critics are overstating their case is that the industry is behind it as a system. In fact, we're seeing major coal-burning companies such as DUKE ENERGY get on board with the concept. They know it's going to cost them, but they want the certainty of concrete rules. And they want to head off what might be coming from the lunatic fringe if something doesn't happen soon.
The third reason cap-and-trade is likely to prevail is that a dozen or so states have already adopted such a system, as has much of the world. Once something is this established, it's hard to introduce a competing system unless there are monumental problems.
So-called global warming skeptics can shake their fists at the sky on this. I'd rather take a long look at some of the beneficiaries of what appears to be inevitable legislation. Wind power is one such avenue, particularly with so many states mandating the use of renewable energy.
Q. WHAT'S YOUR OUTLOOK FOR INTEREST RATES?
A. The threat of rising interest rates is always a concern for those investing for income but perhaps not in the way that gets broadcasted on Wall Street. For one thing, the long-term returns of a high-yielding investment are never determined by interest rates but by the underlying health of its business.
Reading interest rate trends, however, is very useful in one major way. Falling rates often push income investments to overvalue territory, while rising rates eventually make them undervalued.
We're currently in an environment where income investments across the board have moved to very high valuations, in many cases overvalued levels. If we do see a spike in interest rates in the next few months—as we have every year since 2003—it could reverse that in a hurry.
Should that happen, I'll be very aggressive in Utility Forecaster with new buys. For now, high valuations and the recent gradual rise in the benchmark 10-year Treasury note yield are good reasons to buy only what looks like a good value and even to take some money off the table in the stocks that have really moved.
Q. DO YOU STILL LIKE ENERPLUS RESOURCES?
A. In a word, yes. This trust has been around a long time and continues to put up excellent numbers. Management is conservative:
Rather than make every deal in sight in the name of rapid growth, it limits financial risk in any transaction it makes. As a result, debt is low, the payout ratio is stable, costs are low, and the trust has some of the best reserves in the industry.
A good case in point is its recent investment in Canada's oil sands.
If it pays off, this deal could increase Enerplus' overall production by 30 percent or even 40 percent from current levels by sometime in the next decade.
True, it won't generate much cash flow before then--in fact, basically no cash flow to 2011. But the overall value of this deal is only about 2 percent to 3 percent of Enerplus' overall share base. In other words, there's some dilution, but it's really negligible for a trust of this size.
Like all trusts, Enerplus will be affected by trust taxation that's slated to begin in 2011. What I was surprised to learn at the conference is how far along management is with its planning for the post-taxation world. In fact, it has numerous weapons at its disposal to minimize its future tax burden, including an accounting device used by corporations called tax pools. Equally surprising was the fact that management actually seemed anxious for the rules to be set, so it could further develop its business planning.
During the conference, I moderated a panel with executives from Enerplus, Advantage Energy and Pengrowth. All three articulated different strategies for the post-2011 world. But all three did agree pretty strongly on one thing: The returns they would offer investors would depend a lot more on energy prices that on what came out of Ottawa. Based on what we know about Enerplus, it's in good shape on that score.
Q. WHAT DO YOU THINK OF EXCHANGE TRADED FUNDS (ETFS)?
A. You would have had a very hard time moving 5 feet at the Las Vegas Money Show without noticing the proliferation of booths advertising ETFs. They're what Wall Street is selling now, and a large number of investors are buying.
What a lot of investors don't realize is the spreads Wall Street charges when you buy these things. Or the management fees that are taken out for little more than rebalancing the portfolio. Or the fact that many ETFs don't really own what they advertise.
If you're going to buy an ETF, it's critical to look under the hood and see what you're buying. Look for a future Utility & Income to focus on this topic in more detail.
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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