Sweeping forecasts about economic growth and market health are always what claims the headlines. Unfortunately, they’re generally next to useless when it comes to spotting real investment risk.
For one thing, the vast majority of numbers such pronouncements are based on are constantly revised. This week, for example, the gloomy number for US second-quarter growth in gross domestic product (GDP) was revised from 1 percent to 1.3 percent.
Admittedly, the final number is hardly robust. But the upward revision does severely undermine the premise that’s underscored many of the bearish forecasts that have driven the stock market lower in recent months–that the US economy is rapidly plunging toward recession.
So does the drop in US unemployment insurance claims (UIC) last week to 391,000, the lowest level since Apr. 2 when the world was starting to feel the economic shockwaves from Japan’s devastating earthquake/tsunami. It’s also the first time claims have come in below 400,000 since Aug. 6.
UIC is the only measure of employment that’s not revised, as it represents real checks drawn on government funds. The four-week moving average is considered a more reliable gauge. But this improvement was a positive surprise and further indication that, while US growth remains slow and jagged, the economy is still not sinking into recession as so many have taken for granted.
Similarly, predictions of another 2008-style credit crunch seem to change almost daily. That’s to be expected, of course, because at the end of the day all are built on a read of politics, something many if not most investment professionals have a notoriously tin ear for. This week, for example, Germany voted to expand the powers of the European monetary authorities to deal with potential sovereign defaults. That’s something the bears didn’t expect, though most have still been able to make a glass-half-empty retort.
There are times in investing where the macro risks outweigh all else for a time. That was the case in 2008, when a systemic shock nearly collapsed the global financial system. The result was a gigantic deflationary event from which the markets and economy have yet to recover.
This is not 2008, however. Credit markets are tight for the growing ranks of this economy’s have-nots. But they’re still the best ever for Corporate America, as credit risk spreads remain low and the benchmark 10-year US Treasury yield is still below 2 percent, near its lowest level ever. Moreover, company after company has been able to refinance anything coming due in the near future, meaning they can simply step back if the market tightens to wait on better conditions.
Both of these are huge differences between 2011 and 2008. So is the fact that the economy has not yet officially fallen into recession, and the overwhelmingly bearish investor sentiment. The latter has manifested in a “de-risking” spree that’s taken down prices of any dividend-paying stock with perceived risks. But lower stock prices mean a lower bar of expectations. That means less downside risk, so long as the underlying business holds together and the dividend is paid.
There is, however, one very big and dangerous similarity between 2011 and 2008. That’s tough operating conditions in many industries that are a constant threat to the over-leveraged and over-extended. That’s why it’s key to think micro–about individual companies–when it comes to spotting investment risk.
A dividend-paying company that holds it together in an environment like this can still get whacked on a bad day, particularly if it’s the victim of a bearish theme, for example the current conventional wisdom that all tanker stocks are headed for oblivion. But as we saw earlier this year, these are the first stocks investors buy when the markets calm down–and the gains can be massive, in addition to the high yields.
On the other hand, if a company really does stumble as a business, the market can be very unforgiving. That’s particularly true of any company that cuts its dividend. And as we’ve already seen in a few unlucky cases, once a stock falls for that reason, there’s no assurance it will ever get back up again.
That’s one reason my current advice is a policy of zero tolerance for dividend cutters, at least as long as US economic growth remains sluggish. There are sectors with extraordinary rates of recovery from setbacks, such as regulated electric utilities. But with so many stocks cheap and paying high yields now due to de-risking, there are plenty of alternatives to any company that falters.
If you’re like me, you probably find it tough to sell your dividend-paying stocks, even after a dividend cut. For one thing, selling locks in losses that are likely to be quite steep in the wake of post-dividend-cut selling. For another, the yield level may still be quite generous looking, particularly if the price has fallen far enough.
But with the exception of high-yielding oil and gas producers–which have to adjust dividends with energy prices–companies don’t cut dividends unless they’re in trouble. The reasons may be tough competition, a collapsing market for their products or just too much debt. Whatever the case, things are not going well. Mainly, the underlying business is weakening and, barring new evidence to the contrary, one should assume it will continue to falter. The only thing to do is get out.
In fact, of the 211 companies we follow in Utility Forecaster, less than 25 percent make the cut for our Portfolio. Check out the entire How They Rate coverage universe–and my proprietary Safety Rating System–here.
Every sector has its weaklings, some more than others. One place many investors aren’t looking for risk now, however, are the weakest stocks of sectors that are still deemed strong by the investing public. One example: regulated US utilities.
Utilities took a spill as a sector in 2008. Since then, however, they’ve rallied strongly, with the exception of special situations such as Exelon Corp (NYSE: EXC), which is dependent on a depressed wholesale power market in the Middle Atlantic and Midwest US. Many power companies have broken out to all-time highs, while others are at their highest levels since the 2001-02 post-Enron crack-up.
Utes’ strength lies in a growing comfort level on the part of many investors, who rightly see an industry that’s de-leveraged and de-risked dramatically since late 2002. Over that time companies have enjoyed an extraordinary measure of support from local, state and federal regulators that’s been reminiscent of the 1950s and ’60s. And many companies today are boosting earnings like clockwork by adding to rate base with new generation and transmission projects, laying the groundwork for higher dividends and share prices.
One of the truly extraordinary aspects of this economic downturn–the worst since the Great Depression of the 1930s–is there’s been no populist backlash against utility companies in most states. That’s in large part because, unlike during the recession of the early 1980s, electrics have avoided asking for large rate increases.
The big requests of that era were to pay for a new generation of baseload nuclear and coal-fired power plants. The costs of the nukes in particular skyrocketed from initial estimates, as inflation raised costs and post-Three Mile Island regulatory and safety concerns delayed approvals and drew out construction times.
The result was regulators in many states forced companies to write off billions of dollars of construction costs. El Paso Electric (NYSE: EE) and the former Public Service of New Hampshire were driven into Chapter 11, and dozens of companies were forced to slash dividends. Share prices plunged and by the early 1980s, many were questioning the future viability of the industry–illustrated by the famous Business Week cover article titled “Are Utilities Obsolete?”
The BW article was, of course, a classic bottom sign for power companies in general. But the legacy of soaring construction costs of the 1970s and ’80s wasn’t played out by a long shot. By the early ’90s, chafing under the electric rate increases that were approved, industrial customers began pushing industry deregulation through state legislatures.
Power companies were generally successful in winning recovery of “stranded costs” in deregulating states. But managements levered up and took on increased operating risk to “compete.” The result was the near wipeout of 2001-02, the industry’s worst crisis since the Great Depression.
Electric utilities are very visible companies. Even in states that still allow customers to choose between generators and marketers of power, there’s a monopoly on transmission and distribution. And in the vast majority of states regulated monopolies still generate, transmit and distribute electricity, just as they have since Thomas Edison threw the first light switch and his one-time business manager Samuel Insull began building a power business of scale more than a century ago.
Meeting rising demand and reliability needs is expensive and requires constant investment. In fact, a Brattle Group study commissioned in recent years by the Edison Electric Institute estimates the US will need to invest $1.7 trillion over the next decade in power distribution, transmission, generation and environmental protection.
Companies that are able to make that investment and earn a fair return on it have an assured path to earnings growth, which will, in turn, spur higher dividends and share prices. Companies forced to invest that can’t earn a fair return, in contrast, are headed for a repeat of the late 1970s and ’80s.
Even in good economic times, customers don’t like rate increases. In fact, many states employ advocates whose job it is to contest even the most justifiable and needed requests.
Rate increases for any reason are even less popular when economic times are tough. Remarkably, in the spirit of the class of 2002–regulators and executives who came to power following the Enron collapse with a mandate for restoring utes’ financial integrity–there have been no high-profile cases since the economy slowed that have involved major writedowns.
That’s in part because regulators in most states have remained supportive of companies’ financial health. Some states have enacted laws that require recovery of certain costs, such as for replacing and repairing water pipes. Others have laws in place requiring greater grid efficiency and use of renewable energy, which regulators have been required to succor.
For the companies’ part, most if not all have worked to minimize the need for rate increases, at least until the economy gets more traction. Some have done that by bringing down fuel costs, creating savings that flow through directly to customers. Others have delayed or altered capital spending plans.
The happy result is that companies are still generally earning fair returns on their investment. Rate increases are less, so the favorable impact on earnings is less. But utes’ financial integrity is maintained and they’re in that much better shape to fund future needs.
That may be about to change, however, at least for some companies. The El Paso City Council, for example, has ordered the city attorney to open a new rate case in Texas. The reasons cited: El Paso Electric’s power rates per kilowatt hour are higher than most of the rest of the Lone Star State, and the company posted its strongest second-quarter earnings in years.
The company points out that its customers’ bills are actually among the lowest in Texas, as the climate holds down demand. Also, El Paso Electric is the only Texas power utility to declare bankruptcy in recent decades. That move–which was forced by regulatory disallowance of a huge chunk of the costs of building the Palo Verde nuclear plant–has kept the company’s financing costs well above the norm since the early 1990s, which, in turn, has kept other costs high as well.
With the company finally regaining an investment-grade rating, it has been able to bring interest costs markedly lower in recent years. That, in turn, has aided needed investment. So has the restoration of a dividend this year after years of no payout. However, the threat that officials may force a cut–unless management can show why it’s rates shouldn’t be reduced–has already hurt the stock. A particularly steep cut could also threaten the company’s credit rating.
Not surprisingly, a rate cut will make El Paso politicians pushing it popular, and the deeper the better. And if history is any guide, the blow to the utility’s financial health and resulting chill on system investment won’t show up in reduced system reliability and higher costs until the politicians have moved onto higher political office.
The blow to shareholders, however, will be felt immediately. And until this case is resolved one way or the other, El Paso Electric shares are best avoided.
Unfortunately, this isn’t the only potentially vulnerable company. Return on equity (ROE)–a measure used by regulators to determine fair returns on utility investment–has been trending lower in recent years. That follows the general downtrend in borrowing rates and, if fairly applied as is the case in most states, if will not negatively affect companies’ earnings and dividends.
Some states, however, are already making noise that they may use lower ROEs as a lever to push rates lower, as a means of spurring local economies. Possible trouble spots include California, Connecticut, Maryland and New York. Tread with caution if you own utilities operating in these states.
If they can maintain good relations with regulators and avoid punitive cuts in ROE, electric utilities will continue to pay rising dividends, even if the US economy slumps further. Along with water and natural gas utilities, they’re about the safest stocks you can own now. And they’re well protected against a short-term credit crunch as well, by virtue of having refinanced or locking in rates for almost all debt through the end of 2012.
State regulation of ROE, however, is a potential flash point that should be watched carefully by all investors. Potentially vulnerable companies are a major focus of Utility Beat in my advisory Utility Forecaster.
Note the October 2011 issue will be available to subscribers Saturday morning at www.UtilityForecaster.com.
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