Call it déjà vu followed by another dose of déjà vu: For the third year in a row, Europe’s credit woes have thrown global markets into turmoil.
The market’s gains during the early part of 2012 have been wholly undone and then some. Meanwhile, safe havens such as US Treasury bonds and German bunds are in rally mode, with the yield on the benchmark 10-year Treasury falling to less than 1.6 percent this week.
In the global currency markets, the US dollar is gaining ground on rivals as the haven of last resort. While it’s no surprise the euro is crashing, the greenback has also advanced against the Australian and Canadian dollars, currencies backed by countries at or near fiscal balance and with much stronger banking systems than the US.
Since the end of April, the Canadian dollar has retreated from USD1.02 to less than 97 cents. The Australian currency has taken an even harder hit, slipping from nearly USD1.05 to a little over 97 cents. From a US investor’s perspective, declining currencies have added to stock market losses in these countries. And the US dollar value of dividends paid in those currencies has declined as well.
The most important lesson of the 2010 and 2011 selloffs is that dividend-paying stocks will recover, so long as their underlying businesses stay healthy. That was also the case following the historic 2008 crash, which landed us in this environment of sluggish, uneven economic growth punctuated by flashes of deflation and inflation.
Unfortunately, there’s no way of knowing how long the selling will continue, as a market reversal will almost certainly require Europe’s debt crisis to calm. And until that happens, we’re likely to see more stocks head lower, as well as more mini-panics in individual dividend-paying stocks where the payout is deemed at risk.
Ultimately, portfolios will only suffer lasting damage from stocks where dividends are actually cut or eliminated.
In 2011, 2010 and even 2008, underlying businesses remained healthy for the vast majority of stocks that got pummeled. As a result, those stocks did recover, with many ascending to higher highs in the rally that followed.
Two areas of vulnerability, however, have already claimed several victims this time around. And the longer the crisis in the eurozone lasts, the greater the odds it will take down several more companies that have dubious recovery prospects. Consequently, the first step in dealing with the European contagion is to limit your exposure to such stocks.
Companies with dividends that are exposed to falling commodity prices are the first major concern. As I’ve pointed out several times previously, North American natural gas prices have dropped below the level where many producers can profitably operate. That’s already triggered dividend cuts at some Canadian and US producers. And barring a sharp recovery later this year, there will be more dividend cuts to come.
Gas prices have come well off their lows of late April, when the fuel hit $1.90 per million British Thermal units on the near-term New York Mercantile Exchange contract and barely $1.50 in Canada. This week, the US Dept. of Energy reported an eighth consecutive week of declines in the stockpile surplus relative to the five-year average.
That’s partly due to more normal weather, but also to moderating production levels and the increasing use of gas to generate electricity. In particular, the latter is a long-term trend that will provide strong support for future demand for natural gas.
Moreover, not every producer is equally exposed to the recent drop in prices. Many, for example, have aggressively hedged their production at higher prices, thereby locking in cash flow. Others have shifted output to oil and natural gas liquids. A handful, like Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) have such low operating costs that they could earn hefty profit margins even at $1 natural gas. And still others have such conservative financial policies that dividends are sustainable even if gas falls further still.
Unfortunately, concerns about a European contagion have now spread to the oil market, as the price of the near-term NYMEX contract slipped below $86 per barrel this week. And that’s likely to keep all energy industry stocks on the downside until the market bottoms, even infrastructure companies like pipelines that have no direct exposure to energy price swings.
How can you tell which companies are most vulnerable? First-quarter earnings provide a pretty good clue. The higher the payout ratio, the greater the risk, though investors should be careful to use the correct measure of profits when calculating the proper percentage.
Master limited partnerships (MLP), for example, reckon profits by measures of cash flow, generally called “funds from operations” or “cash available for distribution.” That’s also true of the former Canadian income trusts turned corporations. For these types of firms, the usual earnings-per-share metric can actually be misleading at best.
In general, it’s best if a producer’s payout ratio is 50 percent or less of profits. That builds in a substantial cushion against further drops in oil and gas prices. The exceptions are producers that have hedged a sizeable amount of output, such as Linn Energy (NSDQ: LINE). That company has locked in selling prices for all of its expected natural gas production through 2017, as well as all of its oil through 2015.
Owners and operators of energy pipelines, processing facilities, gathering systems and other fee-based assets are not directly exposed to energy prices. A prolonged slump in their industry would hurt growth. But even when oil broke below $40 per barrel in late 2008, companies like Enterprise Products Partners (NYSE: EPD) were able to continue raising distributions.
That’s clear evidence they can withstand the impact of falling oil prices in the wake of the European contagion. Again, that doesn’t mean these stocks won’t be hit by selling during a protracted market downturn. But it does mean a very high probability of full recovery once the crisis passes.
Eye on Debt
Debt is the other key area of vulnerability, specifically where borrowing must occur in the near term. All it takes is a hint of tighter credit to send a stock plummeting, even when all the numbers and news say otherwise.
Consolidated Communications (NSDQ: CNSL), for example, saw its shares plunge after it issued eight-year debt with a yield to maturity of 11 percent. That brought back painful memories of the collapse of other phone companies, even though Consolidated covered its first quarter dividend by a nearly 2-to-1 ratio.
Management also affirmed $30 million to $35 million in annualized operating and capital expense synergies, enough to cover the entire $32.6 million annual interest on the notes. Those facts helped the stock stabilize this week, but only after a plunge from nearly $20 per share in late March to a low of just $13.66 on May 23.
Companies that have had to actually cut dividends to pare debt burdens have fared far worse. Alaska Communications (NSDQ: ALSK), for example, now trades for less than $2 per share. That’s down from a trading range of $7 to $8 per share prior to its 78 percent dividend cut in late September.
I prefer to see companies with no debt coming due between now and the end of 2013. Although the danger of the present macro environment may not subside by then, that time frame does leave companies with plenty of flexibility. And should credit markets tighten like they did in 2008, companies can simply delay any new borrowings until conditions eventually improve.
The most vulnerable companies to the debt debacle are in Europe. Telefonica (NYSE: TEF) was forced to roll back a planned dividend increase for fiscal 2012, but not because of falling revenue. Sales were actually up in the first quarter of 2012 as rapid growth in Latin America offset market contraction in Spain. Rather, it was to save cash for debt reduction, in order to avoid paying loan shark rates to roll over maturing debt.
The good news for that company is management now sees profitability rising in the second half of 2012, thanks to cost cutting and Latin American growth. Meanwhile, partial sales of South American and German units will provide funds to settle debt maturity concerns without saddling the company with additional burdens.
That may or may not be true for other European telecoms or for debt-laden industrials. Most of these will survive this crisis, and some will even emerge in better shape than ever. But the road to that outcome could be rocky, so investors in these sectors must be ready to absorb more volatility and possibly additional dividend cuts.
How will Europe resolve today’s challenges? My best assessment is the eurozone will survive, but only after abandoning austerity to some degree. The price to fund growth will be a drop in the euro’s value against other currencies, including the US dollar.
The key question while we await such a resolution is the extent to which Europe’s downturn impacts economies and markets in Asia and the US. Again, my view is probably more optimistic than most: The market and the economy will plod along, with real pain largely confined to a handful of leveraged and weak companies.
If that proves to be the case, this year’s market slide will prove no worse than what happened in 2010 and 2011. But in case things turn out worse than expected, I’m keeping a keen eye on the companies I own and recommend for any worrisome changes in leverage, dividend coverage or business health. That was the key to emerging from the wreckage of 2008, and it will be the key to weathering a catastrophe of similar magnitude, however unlikely.
For those who want to play more than just defense, I recommend entering buy-limit orders for stocks you want to own, at or below the lows hit in 2011 and 2010. If those orders actually get executed, you’ll own great stocks at very low prices, taking advantage of this momentum-led market to build real wealth for years to come.
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