Lessons for High Yield Stock Market Investments 2008

By: Roger_Conrad

There's still one trading day left in 2007. But for income investors, the key lessons from what was quite a tumultuous year are already in focus, as is how we can use them for a prosperous 2008.

Once again, diversification paid off in spades. Some dividend-paying investments such as utility stocks were huge winners. More economy-sensitive fare like financial's and most real estate investment trusts were losers. But a balanced portfolio of a wide range of high-quality income-payers held its own, generating steady income with low overall volatility of principal.

That was the winning formula for 2007. And with so much turbulence in the air as we begin 2008, it's the best way to play going forward as well.

Barring a total collapse on Dec. 31, the Dow Utility Index will record a 2007 total return in the upper teens, adding to four years of robust gains from the late-2002 low and well ahead of almost any other major US average. A good part of the outperformance in 2007 was due to investors' rush to safety in the second half of the year. But the rally's key underpinning continued to be fundamentals.

A year ago in the January issue of Utility Forecaster, I pointed out that credit ratings had failed to keep pace with the financial strengthening of the sector. This year, ratings at last began to reflect the improving fortunes, capped by Standard & Poor's boost this week in DOMINION RESOURCES' rating from BBB to A-.

In my view, ratings are still below where they should be. But as S&P stated this week: “Credit quality should hold” for electric utilities. The rater went on to say it expects the “US electric utility industry to withstand several challenges in 2008 as companies continue a protracted buildout of needed infrastructure,” though “rising costs for construction materials, fuel, and labor will continue to test the sector.”

If that's the case, we can expect power utility earnings to continue to rise throughout the sector, as infrastructure spending goes into rate base. That, in turn, will keep dividend growth going at a torrid pace. In fact, several companies, including Dominion, have already stated they expect to keep pumping up their payouts at double-digit rates over the next couple years.

The fact that Dominion has committed to rapid dividend increases and still earned a two-notch ratings boost is extraordinarily bullish for the sector in general. In fact, it's the first time since I began writing Utility Forecaster in 1989 that we've seen simultaneous dividend growth and ratings boosts. Rather, since the 1960s, dividend growth has been considered detrimental to ratings boosts and vice versa.

Of course, keeping this incredibly favorable trend going depends greatly on the longevity of today's new regulator/utility compact. And much will depend on what happens in the upcoming 2008 elections.

For now, at least, most states are intent on working with companies to meet the twin challenges of a projected 40 percent increase in power demand by 2030 and combating global warming and other environmental challenges. As long as that's the case, the utility sector will continue to surprise on the upside.

On the other hand, more than a few individual stocks are now fully valued. And even the best are more vulnerable to disappointment as valuations rise.

LESSON #1: NO MATTER HOW BULLISH YOU ARE ON UTILITY STOCKS, IT'S CRITICAL TO OWN INVESTMENTS FROM OTHER SECTORS AS WELL.

What's hot today won't necessarily be tomorrow. And the only way to really protect yourself and keep playing for powerful returns is to diversify.

Note the January issue of Utility Forecaster will be available for subscribers at the www.utilityforecaster.com Web site, starting Saturday, Dec. 29.

LESSON #2: DON'T CHASE THE HIGHEST YIELD—UNLESS THERE'S A ROBUST BUSINESS BACKING IT.

Even seemingly solid high-yielding companies can stumble. And in a risk-averse market like the one that prevailed in the second half of 2007, the resulting selloff can be quite brutal.

The key is whether what's behind the yield is still solid. If so, we hold. If not, we fold.

A good example of the former is BORALEX POWER INCOME FUND, a recommendation in both Utility Forecaster and its sister letter, Canadian Edge. The power generator income trust—which is basically a royalty stream on a portfolio of power plants operated by parent Boralex—reported very weak third quarter earnings, almost entirely because of a 33 percent shortfall in production at its hydroelectric facilities on very low water flows. That, combined with management's decision not to sell the trust, sent the shares plunging in the fourth quarter, and the decline intensified into tax selling season.

Why hold? For one thing, the income fund is in no danger of bankruptcy because it has little debt and is backed by its very solid parent company. The latter actually announced robust third quarter earnings on the strength of its biomass plants. Second, the income fund's hydro plants' output and earnings will rebound very quickly when water flows return to normal.

It's possible the distribution may be reduced next year if water flows continue to lag. But given the parent company's 23 percent ownership stake, its interests are conjoined with Boralex Power Income Fund unitholders to a large degree. In fact, management has announced that the income fund's regular monthly distribution of 7.5 cents Canadian will be paid in January.

The bottom line: If the water flows return to normal in 2008, Boralex Power Income Fund shares are certain to rebound sharply. And even in a worst case, its owners have a tangible investment in a hard asset—power plants—that's certain to survive.

That doesn't mean we're not feeling the pain now. But with the fund selling below book value and pricing in a pretty big (but not inevitable) dividend cut already, it does limit our downside.

In contrast, there's no such assurance for many of the super-yielding fare that crashed and burned in 2007. Mortgage-holding real estate investment trusts, for example, are still challenged to survive amid tight credit conditions and falling housing prices.

If there's a recession in the US, it's only going to get worse, even for those that do survive. Worse, their assets are based on highly complex models, rather than simple things like power plants.

LESSON #3: NEVER, EVER AVERAGE DOWN IN A RAPIDLY FALLING STOCK.

It's one thing to reinvest dividends or to steadily build up your holdings in a growing company. It's another entirely to try to make up for lost ground by pouring more money into a rapidly falling stock.

In my view, the latter invites trouble in two ways. First, you have more money tied up in a single situation, increasing the possibility it can blow a real hole in your portfolio. Second, you inevitably have more emotion tied up in a single situation and, therefore, are that much less capable of making a rational decision should you have to eventually fold the position.

You do reduce your cost basis. But it's simply mistaken that this in any way reduces your risk. If you want to make a bet on recovery, it's a far better idea to choose something similar, rather than pour more money into a single situation that may or may not work out.

Most people who buy for yield took on some water in the second half of 2007. That's unavoidable when conditions are difficult both on the credit risk front and with interest-rate volatility.

But those who doubled down on positions as their stocks fell made out many times worse. And they're far more likely to commit the cardinal sin of all bear markets: selling out near the bottom for emotional reasons.

LESSON #4: HIT ‘EM WHERE THEY AIN'T.

Like generals fighting the last war, investors have a tendency to project the past on the future. In reality, the market almost always works in the opposite direction.

The worst-performing sectors one year may not rebound fully the next. But eventually, they do make it back, while the big winners slide.

Big Telecom stocks AT&T and VERIZON COMMUNICATIONS, for example, were both huge winners in 2007, while Big Cable Television stocks such as COMCAST CORP were losers. That was a complete reversal of prior years, when investors shunned Big Telecom for cable television stocks.

In reality, both Big Cable and Big Telecom had wildly profitable years in 2007, as America's broadband revolution continued. And despite slowing US growth, that trend is likely to continue in 2008.

Nonetheless, Wall Street remains convinced the big boys are locked in a death match. And as long as that's the case, investors will have an opportunity to buy the battered group.

In this case, it's cable television. And given the group's drop in 2007, there's considerable upside for 2008 and beyond.

Until Halloween 2006, Canadian income trusts were red-hot. Then the Canadian government announced its Halloween 2006 plan to tax them as corporations beginning in 2011.

The resulting drop in November priced in the additional taxation and then some in one fell swoop. But some analysts went on to project further losses in 2007, when the plan became law and then from a massive conversion of the group into corporations.

As it turned out, neither of these forecasts came to pass. Trusts across the board have been challenged severely in 2007, as have many businesses in Canada.

The collapse of Canada's natural gas patch amid lower prices has taken its toll on gas-reliant producer trusts and service companies. And many trusts outside the energy patch that were launched in 2006 at the height of the boom have also collapsed because restrictions on trusts' growth made it impossible to issue new shares and tighter credit markets boosted borrowing costs.

It's increasingly clear, however, that a large number of trusts represent growing businesses that will be great investments well past 2011. More than 40 trusts have increased distributions since Halloween 2006, a clear indication they intend to keep paying big dividends past 2011 and that they have the wherewithal to do it.

For one thing, trusts won't pay anything close to the full corporate rate of 31.5 percent but rather something much closer to the 6 to 7 percent paid by the typical Canadian corporation. Some will avoid taxes altogether by virtue of large operations outside the country or by operating in areas that generate large noncash expenses.

The bottom line is trusts with good businesses make good investments. That's particularly true as we head into 2008, with so many trading near book value. And don't forget the three-dozen takeovers of trusts over the past year, some at premiums as high as 40 to 50 percent above pre-deal prices.

Trusts may stay bargains a while longer, with markets concerned about the possibility of a US recession. Sooner or later, however, investors will lose their fear and find their growing yields compelling enough to pour in. For more on trusts, visit my other complimentary e-zine, Maple Leaf Memo ( http://www.mapleleafmemo.com ).

US limited partnerships (LP) are another group likely to get a good bounce in 2008. These were extremely popular at the beginning of 2007 for yield, and Wall Street responded to the demand by issuing new ones in record numbers.

As a result, LP investors were hit by oversupply at the same time the credit crunch began to worsen, and the masses fled for less-complex vehicles.

The oversupply situation is nothing new. In fact, it's exactly what we saw a couple years ago; LPs responded then with a powerful rally in the months that followed. And overblown concerns about credit aren't affecting strong LPs a whit.

There's a caveat this time around, though. Two years ago, virtually all LPs were involved with energy infrastructure, with the model of buying and owning fee-generating assets. As a result, cash flows were exceedingly steady and acquisitions boosted dividends like clockwork.

Most LPs today are still energy infrastructure-oriented. But there are a number from less-stable sectors as well, including energy production. These are good in their own right, but only if investors are aware of the differences.

Mainly, an LP that produces oil and gas will have cash flows—and very likely distributions—that fluctuate with energy prices. They're fundamentally different investments with considerably more risk than the likes of my old favorite ENTERPRISE PRODUCTS PARTNERS, for example, which gets its cash from the use of its facilities in energy transportation, storage and processing.

My colleagues Elliott Gue and Neil George have a new advisory, The Partnership, in which they do a good job making the distinctions that every investor needs to know. I also cover a number of utility-like energy infrastructure LPs in Utility Forecaster.

US REITs are also likely to make a comeback next year. These remain vulnerable to a further slowdown in the property market, however, so tread with care.

Ditto most financial stocks because the full fallout from the subprime mortgage crisis has yet to be felt. Even conservative regional banks could be hit some by economic weakness, though those like REGIONS FINANCIAL are already pricing in quite a bit of bad news that frankly hasn't happened yet.

My general advice is to continue to hold positions in well-run financials such as Regions and REITs, particularly those that have weathered prior crises. But as I wrote above, doubling down in losing positions isn't a good idea, particularly with a real bottom not clearly in sight.

Above all, the key is to stay balanced. My view is you can make a great deal of money by “hitting ‘em where they ain't,” as the baseball adage goes.

But you don't want to be in the position where a single strikeout will send you home for the season. In other words, if you want to bet on comebacks in 2008, be sure to spread those bets.

LESSON #5: WE'RE NOT THE WORLD'S ONLY GROWTH ENGINE ANY MORE.

The US has long reigned as the world's supreme economic power. It was still the biggest engine of global growth in 2007. But as last year proved, for the first time in decades, we're no longer the only engine.

Exhibit A is the world oil market. The robust US economy was a major reason black gold got off to a good start in the first half of 2007.

But despite slowing growth here in the second half, oil prices pushed higher, thanks to continued powerful demand from the world's other engines. And the same was true for prices of many other vital resources.

The conventional wisdom is still that a US recession in 2008 would trigger an across-the-board meltdown for commodities, including oil. That's largely because of the perception that bad times in the US will shut down developing economies in China, India, Eastern Europe, the Middle East and elsewhere.

This was certainly the pattern in the early '80s, when tightened US credit slammed almost every economy in the world. On the other hand, growth in Chinese demand for oil scarcely missed a beat even then. And the world's most populous country is a far more important economy now, with far more domestic drivers and demand for oil.

It's hard to conceive a really bad recession in the US not having some chain reaction effect around the globe. But barring that—which the Federal Reserve is pumping money wildly into the system to avoid—it's very debatable that a slowdown here will have as severe an impact as it would have had even a decade ago or did during the 2001-02 slump.

My view remains that this energy and vital resource bull market will only end when there's at least '70s-magnitude conservation, a permanent switch to real alternatives, major new discoveries of resources and some kind of global demand-killing recession. At this point, the latter is the only real possibility. And as long as that's the case, any drop in prices triggered by a recession will only delay the needed conservation, alternatives and new discoveries needed to permanently destroy demand and end the real bull market.

The result: We're either going to see more price gains for everything from energy to metals and minerals in 2008. Or we'll see a near-term dip in prices because of slowing economic growth that will reverse as things cycle out later in the year. Either way, it's a bullish picture that's not reflected in the current prices of most producer stocks.

The other way to look at this is that foreign-based income generators will remain solid safe havens from more turmoil here. The safest way to go is with utilities and telecoms from these countries because demand for the essential services they produce will remain steady in any economic environment.

And if a US recession forces even deeper Fed interest rate cuts, they're a simple way to hedge your portfolio against resulting declines in the US dollar. Again, I focus on these extensively in Utility Forecaster.

LESSON #6: TRUST NOT TO THE POPULAR PRESS FOR INVESTMENT ADVICE.

How many times have we seen a stock skyrocket or drop precipitously in the wake of an article in the popular press—then invariably reverse in short order, burying those who followed the “advice”?

When the market is rallying, hype-ish “buy now” articles are much more common. In the fear-wrought climate of the past half year, however, it's been the “sell now” items that generate the most interest and the greatest fallout in the marketplace.

There's certainly been no shortage of bash ‘em targets this time around. One favorite to kick around in 2007 was Australia's MACQUARIE BANK and its infrastructure investment funds.

The bad press began in the spring with charges that the bank had made its purchases at uneconomic prices financed by cheap credit converted into a mountain of debt. Some went so far as to compare the situation with Enron and advised selling anything with the Macquarie name on the door.

Predictably, share prices have come down. But even as virtually every other major bank in the world has posted huge subprime losses—with more almost certainly to come—Macquarie has held its own, and so have all of its various and sundry parts.

In fact, in late October, the bank announced the takeover of yet another major US utility, PUGET SOUND ENERGY. Apparently, “the next Enron” isn't yet having trouble raising credit or continuing its supposedly uneconomic growth strategy. The only losers have been those who listened to the popular press and cashed out.

This week, we saw another example of wrongful bashing in the utility and infrastructure universe. In last weekend's edition, a Barron's article slammed fast-growing seawater-to-freshwater company CONSOLIDATED WATER, charging that the shares could fall as much as 50 percent if a supply deal with the British Virgin Islands (BVI) wasn't renewed on favorable terms. The immediate result was a one-day drop of 23 percent in Consolidated's share price, the biggest one-day decline in the stock since October 1996.

Political and regulatory risk comes with the territory for companies like Consolidated that operate across international borders. But several items here don't pass the smell test.

First, the article was published so that the first trading day afterward was Christmas Eve. Dec. 24 is notoriously one of the lightest trading days of the year.

The fact that the Christmas holiday was Tuesday this year meant that more analysts and traders than usual were out of the office. As a result, the potential volatility was at a maximum, particularly in a stock with a total market cap of only around $350 million.

Second, the article was published without substantiation from either Consolidated Water or the BVI government. That's despite the fact that the dire forecast was based entirely on a supposed understanding by the author of the dispute.

Third, there was no real explanation of where the 50 percent downside forecast came from because the numbers clearly don't add up. What's at risk is a $16.9 million investment in one now-operating plant, $8 million in a new plant built by Consolidated in good faith to meet projected new demand, a management services deal for the plant worth $856,000 and about $2 million in income recognized over the past two years from BVI operations.

Per the company's Nov. 28 filing with the US Securities and Exchange Commission, the risk is: “If an arbitration panel or court determines that the BVI Government owns the Baughers Bay plant, OC-BVI could lose its water supply agreement with the BVI Government and its ownership of the Baughers Bay plant. The arbitration panel or court could also determine that OC-BVI is not entitled to full payment of amounts previously billed to the BVI Government. In either case, the value of the Company's OC-BVI-related assets would decline, and the Company would be required to record impairment charges to reduce the carrying values of these assets. Such impairment charges would reduce the Company's earnings and could have a significant adverse impact on the Company's results of operations and financial condition.”

Assuming the company loses all of its current income from BVI, earnings would be reduced by approximately $2 million. That's a hit of between 15 to 20 percent based on 2007 earnings, though the hit on 2008 is likely to be somewhat less as Consolidated adds projects in other countries.

Assuming it has to write off its entire investment in the two plants and the management contract's value on the books, the total hit to equity is about $27.8 million. That's versus a Sept. 30 total shareholders' equity of $116 million, which again rose about 10 percent last year as the company increased investments.

Granted this would be a hit. But even using these worst-case outcomes, it's hard to see where it adds up to a 50 percent drop in the value of the entire company. Moreover, not even the BVI government is proposing a wholesale taking but rather a lower buyout price for the facilities than the company says the assets are worth. And the case is to be decided by the courts, not BVI government fiat.

The bulk of Consolidated's operations are still in its original home market of the Cayman Islands, and it's growing operations in Belize, Barbados and Bermuda as well. Major projects in the Caymans and Bermuda of equivalent or larger size than the BVI operations are slated to come on line in 2008. Moreover, the BVI operations are relatively new and organized as an equity investment in affiliate OCEAN CONVERSION, limiting legal risk to the investment itself.

Finally, as long-term holders know well, Consolidated has literally weathered much more difficult times than this. Most notably, a couple years ago, Hurricane Ivan virtually shut down its key subsidiary on Grand Cayman.

The shares plunged, but management got its facilities back on line in a speedy and economic fashion while maintaining its strong relationship with the Cayman government. Today, the company has resumed its rapid growth and is more popular with home country officials than ever.

Since Christmas, Consolidated shares have already reclaimed about half their losses. The analyst with historically the best record forecasting the stock has weighed in with the opinion that the BVI situation is far from approaching the worst case and has a target price of $35 a share. And apparently others have taken a look at the numbers as well.

In my view, the most likely scenario is some sort of compromise where Consolidated gets at least partial value for its investment and takes the writeoff on the rest. Then it focuses its expansion on more profitable markets like the Caymans, and the stock moves onto higher highs. In the end, the only losers will be those who tried to bail out on Monday in the wake of the Barron's article and got clobbered.

Unfortunately, this won't be the last time we see this kind of action/reaction. It may even happen in Consolidated again, given the stock's extremely volatile trading history.

Fortunately, the key to surviving the blow of mass media-driven selling or buying is relatively simple: Before you leap on advice given in Barron's, The Wall Street Journal, CNBC or any other popular source, take the trouble to look into the situation yourself.

Where there's smoke, there's usually fire. But sometimes, it's just a smokescreen. Inhale at your own risk.

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.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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