Treats and Traps of 2012

Not every Utility Forecaster recommendation did well in 2011. But for the third straight year since the 2008 meltdown, the overall Portfolio was solidly in the black. That’s exactly what I expect for 2012, though investors face potential traps as well as treats.

Last January I forecast opportunities in takeovers, pipelines, energy producers with surging output, big communications, dividend growth and the Canadian dollar. Each proved profitable, though some individual companies faltered.

This year I look for the US economy to beat extremely low expectations. But leveraged and less careful companies will still slip, and commodity prices could swing widely depending on Europe’s ongoing sovereign debt crisis.

Meanwhile, US government regulation has suddenly become much less predictable, as the Obama administration fires up the Democratic Party base ahead of November elections.

Below I highlight the major themes for utility and income investors in 2012, positive and negative. I pinpoint likely winners, most of them also reviewed elsewhere in this issue.

Keeping Conservative

Six years of slashing debt and operating risk enabled utilities to dodge the worst of the 2008-09 crash. The good news is utility managements are still keeping it conservative.

Record-low corporate borrowing rates are enabling even sub-investment-grade companies to slash interest costs and push out maturities. (See Utility Beat.) Even in an unlikely reprise of 2008 most could simply pull offerings and wait for better conditions.

The upshot is the strongest utility balance sheets in decades and revved-up dividend-growth potential. That’s a major reason to be bullish on our UF Portfolio dividend-paying stocks in 2012.

The downside is bond yields are too low and prices too high to merit buying, so stocks are literally the only game in town.

The UF Portfolio rules are designed to control risk of dividend-paying stock portfolios in turbulent times. They are:

• Keep track of your companies’ business health and sell if they falter.
• Buy and hold at least 15 to 20 stocks from a range of sectors.
• Sell a piece of winners periodically to balance your holdings and use proceeds to buy stocks you don’t already own.
• Never use stop-losses or average down.
• Set buy-limit orders where possible.
• Buy for growth as well as yield.

The key to avoiding big losses in 2011 was to limit potential damage from the individual stocks that did blow up. That’s still our paramount task in what should be an “up” year, but with even the strongest companies still at risk to a stumble.

The New Yield Curve 

The link between dividend-paying stocks and so-called benchmark interest rates is busted. The new yield curve is based on perceived risk to dividends.

During the first few months of 2011 many investors chased the highest yields they could find. That changed with the “Black Swan” events of spring–Japan’s tsunami/earthquake and the Arab uprising–and accelerated as Europe’s sovereign debt crisis worsened.

As a result the gap between individual stocks’ yields has widened dramatically, based on investor perceptions of risk. That difference will likely endure so long as the current climate of fear does.

In fact, spreads will likely widen every time a company cuts its dividend. If today’s high-yield companies can hold dividends intact, however, they should be huge winners in 2012.

That’s the rationale for sticking with the stocks on the high end of the new yield curve. Lower-risk examples include high-yield telecoms such as Consolidated Communications (NSDQ: CNSL) and Windstream Corp (NYSE: WIN) as well as Atlantic Power Corp (TSX: ATP, NYSE: AT) and Energy Transfer Partners LP (NYSE: ETP). All four companies enjoy strong dividend coverage and yield around 8 percent.

Higher-risk fare include ENEL SpA (Italy: ENEL, OTC: ESOCF, ADR: ENLAY), Frontier Communications (NYSE: FTR) and Telefónica SA (Spain: TEF, NYSE: TEF). Each faces challenges but is still fundamentally solid. They’re suitable for holding in diversified portfolios, which will minimize downside should their fortunes worsen.

Currency Kickers

Perhaps the biggest market surprise of 2011 was the surge in the US dollar following Standard & Poor’s US Treasury ratings cut in August.

The move effectively spurred panic buying of Treasuries and, by extension, the US dollar.

By late September the yield on the 10-year Treasury note had fallen to less than 1.7 percent. That was nearly half a point lower than in late 2008, when the credit crunch/market crash spurred a similar rush to safety.

And it triggered a surge in the buck versus nearly every major currency.

The euro was one of the biggest losers, due to speculation it might not survive. But compared to 2008, the natural resource-driven Australian and Canadian dollars have lost little ground, bottoming at about USD0.94 this fall.

That compared to an early 2009 low for the loonie of USD0.76 and a late-2008 low for the Aussie dollar of just USD0.63.

These currencies’ relative strength is due to investor recognition of superior fiscal balance and healthy banking systems. That’s offset extreme price volatility for natural resources, including oil.

And it bodes well for future appreciation, when the climate of fear gripping the markets inevitably lifts.

My top currency kicker pick from the January 2011 Feature Article–Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–proved to be a huge winner, despite the dip in the Canadian dollar. In fact, like many pipeline stocks it’s a bit expensive. I’d be an enthusiastic buyer of Pembina Pipeline on a dip to USD25.

But ARC Resources Ltd (TSX: ARX, OTC: AETUF), Atlantic Power and Brookfield Renewable Energy Partners LP (TSX: BEP-U, OTC: BRPFF) all trade below my buy-under targets as of press time.

My favorite Australian stock is fast-growing pipeline company APA Group (TSX: APA, OTC: APAJF). The country’s new tax on carbon dioxide emissions is boosting demand for natural gas to generate electricity. APA’s deep pockets and wide reach uniquely position it to profit.

The company pays a dividend of nearly 8 percent, which it recently raised 3 percent. Buy APA Group up to USD5.

As for the euro, my view is it will survive, though with greater integration of economic policy and possibly fewer countries. Meanwhile, the euro-US dollar exchange rate will be volatile, pressuring the US dollar value of European utility stocks and dividends. The offset is these risks are much more than priced in for ENEL and Telefónica.

Ditto France Telecom SA (France: FTE, NYSE: FTE), which according to Fitch–by far the credit rater with the most credibility–“is a conservatively managed business with enough liquidity to stay out of the bond markets for the next two years.”

That’s a luxury rivals can’t afford, which should strengthen the company’s competitive position in 2012. Buy France Telecom’s New York Stock Exchange-listed American Depositary Receipt up to USD16.

Capital Games

Last year I forecast “another wave” of essential-service company mergers, driven by low capital costs and a need to gain scale. Both are still catalysts for utility deals, but a major obstacle to M&A has since emerged: Obama administration regulators increasingly mindful of approaching November elections and anxious for low-risk opportunities to stir up anti-corporation/pro-environment sentiment within the Democratic Party base.

The first casualty was AT&T’s (NYSE: T) proposed buyout of Deutsche Telekom’s (Germany: DTE, OTC: DTEGY), which the former cancelled due to concerted opposition from the US Dept of Justice and the Federal Communications Commission  (See Utility Beat.)

It may not be the last rejected, though the six Utility Forecaster Portfolio picks involved in ongoing deals look solid either way. (See Portfolio Update.)

Until the past few months, the Federal Energy Regulatory Commission routinely ruled expeditiously on utility mergers. Now it’s taking even longer than notoriously contentious states like New York.

Even the Federal Trade Commission is getting into the act by challenging deals outright, or delaying them by requesting more information.

The upshot is a new hurdle to utility mergers that’s likely to curtail activity until after the election, with the exception of deals small enough to get under the radar.

One potential target, with a fleet of low-cost natural gas power plants that’s benefitting from falling gas prices, is Calpine Corp (NYSE: CPN). It’s still an attractive buy up to 16.

Pipelines are also good candidates for deals, though most are considerably more expensive than they were before the Kinder Morgan Inc (NYSE: KMI)-El Paso Corp (NYSE: EP) merger sparked takeover speculation.

One good candidate is Provident Energy Ltd (TSX: PVE, NYSE: PVX), which has a fast-growing natural gas liquids asset base in Canada. Buy up to USD9.50.

New Environmental Protection Agency rules for coal-fired power plants’ mercury, acid rain gases and particulate matter have apparently pleased the Democratic Party base.

Meanwhile, the estimated $9.6 billion cost is less than initially proposed and companies have some flexibility on timing.

In contrast, there’s no middle ground for pending Nuclear Regulatory Commission decisions on relicensing Entergy Corp’s (NYSE: ETR) Indian Point (New York) and Pilgrim (Massachusetts) nuclear plants.

Nor is there for Southern Company (NYSE: SO) and SCANA (NYSE: SCG) requests for permits to build new nuclear reactors based on the AP1000 design, or for TransCanada Corp’s (TSX: TRP, NYSE: TRP) proposed Keystone XL pipeline.

My guess is the AP1000 gets approved in early 2012, while rulings on re-licensing and Keystone XL wait until after the election. That’s reflected in optimistic pricing of SCANA and Southern, which are above my targets.

Entergy and TransCanada, in contrast, reflect very low expectations and are therefore high potential buys up to 75 and 43, respectively.

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