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FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

International Miners and Power Utilities Strong During US Financial and Economic Crisis

Companies / Emerging Markets Dec 15, 2007 - 09:24 AM GMT

By: Roger_Conrad

Companies Best Financial Markets Analysis ArticleWhen the US economy and markets sneeze, the rest of the world catches a cold: That old investing adage has held for nearly a century, since this country first became dominant on the global scene after World War I.

Conventional wisdom is it will hold this time around as well. But based on the numbers we've seen thus far, that's far from certain.


In years past, the rest of the world was far more dependent on the US than we were on it. For example, the timely action of the Greenspan Federal Reserve and Clinton administration in 1998 effectively stanched a financial crisis that had been building around the world to that point, taking down entire countries such as Russia.

The current financial crisis, of course, is a mirror image of the one nine years ago. Rather than germinating in excesses abroad, this one was made right here in the US, as global financial institutions pumped up the US mortgage market and then dramatically leveraged their balance sheets to its health.

In other words, the pain is being felt here first. The rest of the world continues to grow, in some places very rapidly. The question is how much will US weakness eventually affect the economies outside our border, particularly if it should worsen.

In 1998, the world basically had one major engine of economic growth, the US. Only a coordinated move by the US could head off the crisis. And given the heft of our economy then, that's all it took.

Today, several major economic zones are growing rapidly: China, India, emerging Asia, Central and Eastern Europe. The key question is how much that growth still depends on the US economy and markets. That will determine how much the world can stand in a US crisis as much as how bad things wind up getting here.

Unfortunately, we're only going to get answers to these questions by living through the current financial crisis. But at least two things are clear. One is America has sneezed, but most economies aren't yet suffering its affliction.

That suggests economies like those in emerging Asia are rapidly becoming more independent from the US. And it means that things are probably going to have to get much worse here before other economies really come down.

On the other hand, stock markets the world over are closely following the US economic news. A selloff in the US has almost always been followed by a drop in Asia the next morning and then pressure on the European markets.

Clearly, the global financial system is more closely connected than ever. The subprime mortgage- and asset-backed securities issued here based on US mortgages have made their way into the portfolios of banks and countries from places as remote as Kazakhstan.

So it's no surprise that weakness in the US financial sector has spread overseas. That's a major reason the foreign central banks have moved so aggressively to cut interest rates and inject liquidity into the system.

There's a group of stocks, however, that's holding up very well. In fact, it's the same sector that's been outshining here in the US: utilities.

Like all utilities, these companies' bread and butter is essential services. No matter how bad things get where they operate, people are going to pay them for electricity, heat and water. That translates into exceptionally steady cash flow and dividends.

In recent years, the European Union has attempted to encourage competition in these sectors, officially abolishing the monopolies and actively trying to tilt the playing field toward new entrants. As in the US, however, its efforts have largely had the opposite effect.

Rather than falling apart and fading away, the former monopolies have become more dominant than ever. And freed from the shackles of tight rate regulation, they're more profitable than ever as well.

Global utilities have two other major selling points for US investors. No. 1 is that they're priced in foreign currency and their dividends are paid in their home country's currency.

The US dollar has rebounded somewhat in recent weeks. One reason is foreigners have been heavy buyers of our debt securities as safe havens. That may continue to be the case as long as recession fears percolate globally. But in the past several years, the direction for the greenback has been down.

Given our deficit spending, the long-term trend for the US dollar is likely to remain down for some time, with the drop resuming as a bottom for the US economy starts to come more into view. My guess is that will happen in the first half of 2008. And when it does, the US dollar value of foreign utility stocks and their dividends will resume its multi-year uptrend as well.

Owning foreign utility stocks, then, is a great way for US investors to hedge our natural exposure to our home currency's weakness.

The other major selling point is growth. As I've pointed out in past issues of Utility & Income, the US utility universe no longer moves in lockstep.

In fact, in stark contrast to the old monopoly days, virtually every company's business mix is different. As a result, while some US utilities offer basically no growth, others offer explosive upside in coming years.

The world's fastest-growing economies, however, are outside the US. Foreign-based utilities are directly tied to the growth of those economies.

Electricity demand in China, for example, is growing at a rate of more than 10 percent a year. That's wired in growth for its major electricity generation companies such as HUANENG POWER INTERNATIONAL, making them ideal for investors to cash in on that growth.

Emerging economy growth, of course, has historically been far more volatile than growth in developed lands. But foreign-based utilities also offer a safety advantage not shared by stocks in any other sector: They're recession resistant.

Simply, like US utilities, they produce essential services that people, businesses and governments can't do without. Even when the rest of a country is crashing, they still offer stability.

Just as state regulatory environments define US utilities' risk, so is the risk of foreign utilities governed by their host country regulation. In good climates, companies will grow and thrive. In hostile ones, financial trouble is only a matter of time. In fact, outright nationalization—as Venezuela did with its dominant power and telecom companies this year—is even a possibility.

As a result, an assessment of the regulatory environment is the best possible starting point for analyzing foreign-based utilities, just as it is for their US counterparts. Similarly, a company that has exposure to several regulatory environments will limit its risk to a disaster in a single market.

That's why my favorite foreign utilities are those that have spread their risk. The Utility Forecaster portfolios list several in this group. My favorites in the power sector are AES CORP, CLP HOLDINGS and ENEL.

Based in Northern Virginia, AES operates a growing portfolio of power plants and regulated utilities on every major continent. The company enjoyed almost uninterrupted growth up until the 2001-02 utility bear market. At that point, it nearly collapsed under the weight of a huge debt burden and a dispersed asset mix that was almost unmanageable.

But the company's principals Roger Sant and Dennis Bakke—who had built the enterprise from scratch—then took a step back. They hired consummate global insider Richard Darman as chairman of the board and Paul Hanrahan as CEO. The company almost immediately began to recover, and it's never looked back since.

AES' current thrust is green energy, and it plans a massive build-out of wind, solar and biomass globally, particularly in China and the US. As the somewhat disappointing initial public offering (IPO) of Spanish utility IBERDROLA'S unit Ibernova showed this week, green power's no investment market shoo-in as long as recession fears percolate. But it's making a lot of money for those who control it, and those returns are showing up in AES' pocket in a big way.

The company has a great deal of exposure to Latin America. But again, that's a calculated risk, and diversification goes a long way toward protecting the overall asset base. AES' forced exit from Venezuela this year, for example, scarcely put a dent in its growth.

CLP Holdings is a direct bet on the runaway growth of power demand in Asia, particularly China. The company's Hong Kong utility core is likely to get a lower rate of return for the next five years than it's enjoyed the past five; that's the upshot from recent noises coming out of the city's government. But it has more than enough growth opportunities—including in Hong Kong—to pick up the slack.

For example, the company is building a liquid natural gas terminal in Hong Kong that will service its needs and earn it fees as it enters the rate base. Moreover, Hong Kong is one of the few economies that's historically been able to routinely withstand weakness in the US, and demand for power continues to grow steadily.

CLP's real opportunities are outside its borders. The company's direct exposure to mainland China has been limited to a few targeted investments. That's held growth to less than it might have been. But it also limits exposure to a potential cooling off of that red-hot market, and there's a lot of upside for new projects.

CLP has, however, been a prolific acquirer of assets throughout emerging Asia. The company's latest target is India, but it's done very well in a score of other nations as well, including Australia. It also pays a generous dividend of around 5 percent.

Few people are aware of it. But the emerging economies of Eastern and Central Europe are collectively growing almost as rapidly as China and emerging Asia. Italy-based ENEL has positioned itself well to take advantage, building plants in several countries and taking a major stake in Russian utilities and natural gas.

The company, which is also a major player in African gas transport and sales, enjoyed its greatest coup to date earlier this year. That's when it hooked up with Spanish conglomerate ACCIONA to take a controlling interest in that country's largest power company, ENDESA.

The deal dramatically expands ENEL's presence in Europe, particularly Spain. And it also adds numerous assets in Latin America, where the market for power is growing rapidly, if not a bit erratically.

The primary asset is a controlling interest in Chile's Enersis, which itself has a growing presence in the Mercosur or Southern Cone countries. A focus on this region has particular appeal in light of the US economy's difficulties because it's the furthest away from our troubles.

Countries such as Argentina, for example, have always had a closer connection to Europe than to the US. Now, they're also forging closer ties to emerging Asia. The result is solid power demand, even if things tail off further here.

As for dividends, AES doesn't pay one. It does have a PREFERRED C note, however, that's convertible into common stock and pays around 7 percent. It's callable at 50, and it's conversion value is still well below the current price—a hangover from the 2001-02 collapse. So the common is a more direct play on the company's continued growth.

CLP's American Depositary Receipts (ADR) pay a regular quarterly dividend, basically an anomaly outside the US and Canada. ENEL's payout, meanwhile, is twice yearly and varies with profitability. Management, however, has been more than generous divvying out the cash, and it can afford to, given the company's deep prosperity.

One thing US investors in all foreign equities need to be aware of is foreign government withholding. Basically, it's standard practice for host governments to take 15 percent of all cash dividends paid to US investors right off the top before it shows up in investors' accounts. That percentage is actually higher for nationals of other countries.

As a result, your net dividend is usually about 15 percent less than the gross dividend. The good news is you can get back the withholding when you file your US taxes by filling out a Form 1116.

The bad news is the amount you can get back in a given year is governed by how much in taxes you're paying elsewhere. If your rate is sufficiently low, you can't get the full amount back in that year. You can, however, carry the credit forward to future years.

It's a pain, and we can all wish for a time when free markets and free borders truly reign. For now, it's just a cost of foreign investing and well worth bearing, given the rewards for owning the right companies.

There's one additional way conservative investors can play global growth and the resistance of foreign economies to US woes: selected vital resource stocks.

I've noted here that my colleague Yiannis Mostrous and I have launched a new service, Vital Resource Investor (http://www.vitalresourceinvestor.com), that's devoted to stock plays on these opportunities. Results so far have been a nice counterweight to some of the turmoil in other sectors I recommend, such as Canadian income trusts and other super-yield plays.

As I wrote last week, high yield is to this decade what high tech was to the 1990s. And just as high tech went on to monster profits following that decade's credit crisis, so should high yield this decade. That's why you want to stick with the best of these sectors: namely investments that can maintain those distribution streams during the market's current “stress testing.”

On the other hand, it's nice to be making money in one of the few sectors—besides utilities anyway—that's doing well. Unlike utilities foreign and domestic, vital resource stocks are volatile animals. And like any other sector, no one should overload on them.

But with today's inflation numbers looking a little scary and signs of economic weakness growing in the US, the miners of increasingly scarce iron ore, aluminum, platinum and so on are increasingly attractive.

Meanwhile, like utilities, merger mania is heating up in the sector and indications are that premiums are going to be substantial. This week, for example, a Chinese steel giant made a billion-dollar cash bid for a small Australian iron ore producer. An equal offer would value RIO TINTO'S iron ore business alone at USD110 billion versus a current market capitalization for the entire company of just USD140 billion.

Rio, of course, has been targeted for takeover by fellow diversified Australian giant BHP BILLITON. Rio charges BHP's offer of three of its shares for one Rio share is far too low. And it has a real point. Mainly, iron ore accounted for about 30 percent of income last year, and that was before the ALCAN takeover beefed up its aluminum business.

Rio Tinto's far from the only vital resource company in play. In fact, this cost-pressured industry is certain to increasingly consolidate, with extremely deep-pocketed Chinese mining companies setting the pricing more and more.

China needs resources to keep its growth going and is willing to pay up for them. We may as well take advantage as investors.

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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