There are many potential signs of a company in trouble. The surest I’ve found, however, is when management dramatically revises its guidance to the downside from what it’s said earlier.
All sorts of things are said during conference calls. And it’s the job of executives to paint the best possible picture of how their company is doing. There is, however, only so much lipstick you can put on a pig, so to speak. And when management’s outlook deteriorates sharply from one quarter to another, it can’t be good, no matter how much the news is sugar coated.
Note that I’m talking about the company’s internal guidance, not the opinion of analysts who issue earnings forecasts. Meeting or beating the consensus estimate of a company’s earnings or revenue is always the headline for news stories on profit reports. But in reality, it’s actually pretty meaningless information.
In fact, very often a stock will rally sharply when the headline claims it missed estimates. That’s because those estimates didn’t really reflect the level of market expectations for the company.
Significant disappointments or positive surprises can and do move stock prices in the near term. That’s one reason why it’s important to keep an eye on valuation as well as companies’ actual health. The former reflect the level of investors’ expectations, and the higher they go the more difficult they are to meet, much less beat.
Conversely, a low level of investor expectations is much easier to beat, and therefore trigger an upside surprise in the near term. Long-term performance, however, is far more correlated to management’s ability and execution of company development and growth. And again, there’s no better gauge of that than how the company is measuring up to its internal guidance.
The Exelon Incident
So long as guidance is consistent and I’m sold on the company’s long-run prospects, I’m willing to overlook a lot of near-term turbulence. Earlier this year, for example, Exelon Corp (NYSE: EXC) cut its dividend by 41 percent, in response to the expiration of long-standing price hedges for its sales into unregulated wholesale power markets.
Wholesale power prices in the company’s key markets have fallen 45 percent since 2008. And after the company’s merger with Constellation Energy last year, unregulated energy sales account for more than half of its profits.
Dividend cuts are, of course, frequently a clear sell signal. For one thing, they indicate management’s assumptions of company health were overly optimistic. And in the case of Exelon, we were already deep in the red in the position.
What made the company’s payout cut atypical was that it was long expected. In fact, management had warned for several months that it would reduce the dividend to maintain its investment grade credit rating, were wholesale power prices not to rebound. When that appeared to be the case, they made their move.
Exelon’s guidance in other words was consistent and the dividend cut was not a surprise. That in turn kept the stock stable following the news. And even more important, management was able to lay out a clear plan for an earnings and share price recovery when wholesale power market conditions eventually improve.
As the nation’s leading power producer from nuclear plants, Exelon has been hurt by low natural gas prices, and their negative impact on wholesale power prices. Unlike gas, however, nuclear plants have a long history of stable operating and fuel costs. They also emit no carbon dioxide.
Speculation continues to grow that we’ll see some form of CO2 regulation in the US in coming years, and possible a carbon tax. Were that to happen, Exelon’s nuclear output would suddenly become a lot more competitive vis-à-vis gas. And margins would likely get an additional boost from higher wholesale power prices as well, as owners of gas-fired plants tried to push through costs to buyers.
The result would be a faster recovery for Exelon than almost anyone expects. But even if there is no CO2 regulation, gas and wholesale power prices will eventually move higher, as capacity for exporting North American natural gas expands. That means a slower recovery, but a nonetheless inevitable one.
Obviously, it would have been better not to own Exelon over the past year. But the post-dividend cut buy/hold/sell decision boiled down to whether guidance was consistent, as well as the odds of recovery. And utility stocks in general have an unblemished record of recovering from almost any disaster in spectacular fashion.
The Power of Price
The other reason for long-termers to sell is price. I’ve found my greatest temptation is to let winners ride and sell off losers. Ironically, if you’re living off dividends from your stocks, the prudent course is often just the opposite.
For one thing, one year’s underperformers are often the biggest winners the next, at least so long as the underlying company is still making its nut. More importantly, however, the more a stock appreciates relative to everything else in your portfolio, the greater the risk to your financial health if something unexpectedly goes wrong.
None of us have perfect knowledge. And in an environment where austerity may be slowing US growth faster than most people think, even the strongest looking company can stumble.
Diversification and balance—not letting any one holding grow out of proportion to your portfolio—is how you limit this risk. The tactic is to get in the habit of periodically selling a piece of your biggest winners, and reinvesting in something of similar quality that’s not so expensive.
Yes that requires a little digging around to find something else. But the more dividend-paying stocks you own, the safer you’ll be from the inevitable stumbles.
Moreover, this is a market as much ruled by buying momentum as selling momentum. And the converse of investors panic selling stocks perceived at risk is a buying frenzy for stocks deemed “safe.” That means frequent opportunities to take partial profits in companies that shoot up to price levels they can’t sustain.
Of course, for we “buy and holders,” that may be more activity than we’re willing to support. And selling does have consequences, such as taxes owed and commissions to pay.
But the more you get into the habit of periodically culling your holdings and eliminating such things as over weighting, the more reliably your portfolio will build wealth and provide reliable income. And that after all is the goal.
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