Investing Daily

On July 1 shares of Frontier Communications (NYSE: FTR) traded as high as $7.72 and as low as $6.96 per share before ending the day at $7.69. Volume of 30.1 million shares was six times that of the typical day in late June. And the action continued fast and furious on July 2, with nearly 50 million shares changing hands.

Should investors be concerned about such wild action? The answer depends on two things: objective and leverage.

If you’re a trader employing margin or buying/selling options, days like these are enormously important. In fact, betting on them correctly is the difference between success and failure.

In contrast, there’s only been one important question last several days for income investors who own Frontier: Did the volatility signal a threat to the company’s financial health and, by extension, its distribution?

If so, it would be a direct warning of potentially severe losses to come in the stock. If not, the volatility would pass like a summer squall, leaving the shares at much the same price where they traded before the action.

In the case of Frontier, the answer is the volatility is purely the result of technical rather than fundamental factors. July 1 marked the close of the company’s purchase of 4.8 million rural phone lines from Verizon Communications (NYSE: VZ). The majority of the purchase was paid for by dishing out 0.238 shares of Frontier for every share of Verizon.

The deal left Verizon shareholders with 68 percent of the stock in post-merger Frontier. With the company yielding around 10 percent based on a post-deal dividend rate of 75 cents per share, income investors have no doubt found this arrangement to their liking. Rather, the volatility was almost certainly caused by selling from at least several of the institutions that own the majority of Verizon shares, which were forced to unload positions for portfolio management reasons.

This is typical action for any merger, but it created extremely atypical activity in Frontier, an otherwise steady stock. And with the memories of late 2008 still so fresh in investors’ minds it’s no wonder the volatility drove up the heart rates of many risk-averse shareholders.

I fully expect to see similar ups and downs over the next several months, particularly for any company making a major strategic move. But as was the case with Frontier, few of them will actually involve anything to do with an underlying business, and hence be worth acting on.

The key will be simply getting a read on what’s really going on at the company’s underlying business. And if you’ve been keeping up all along, odds are nothing has happened, the business is still solid and the essential thing will be having the fortitude to hang on to your shares until the madness passes.

Frontier now pays a quarterly dividend of 18.75 cents per share versus 25 cents before the merger. Management announced the reduction months ago at the same time it announced the deal, and the CEO recently characterized it as “temporary.”

Moreover, the new rate is now covered by nearly a 3-to-1 margin by free cash flow, leaving much left over to reduce debt and make needed capital expenditures to upgrade the Verizon systems to its broadband offerings. The new lines offer much opportunity for this, as well as expansion of the company’s burgeoning commercial business.

In other words, this merger strengthened rather than weakened Frontier. Completing it on July 1 posed no threat to the company’s dividend, and therefore it was no threat to the long-term value of the stock, which still yields more than 10 percent. The upshot: Its effect is temporary.

There are, of course, stocks that fall because the underlying company is faltering. But the lesson here is a strong business means a solid dividend. And that means any damage to the stock will be short-lived. We saw it in the aftermath of the Flash Crash in May and before that in late 2008.

Focus on the business first. And daily action is only important if it’s in response to something real at that business. Otherwise, income investors have no business reacting. And that’s particularly true if you have a diversified and balanced portfolio of high-quality yield investment spread across several sectors and investment classes.

One final point: I continue to advise investors avoid the use of stop-losses, particularly trailing stops. These don’t lock in a selling price. Rather, they’re sell orders that are executed when a certain price is reached. And if there are enough other stops at that price, the sell orders will drive down the price of the stock well below the stop price you’ve set before you’re cashed out, only to watch the shares rebound.

Stops are guaranteed to whipsaw you out of good stocks on bad days, as no doubt happened to some Frontier investors. If you’re so uncertain about a company’s underlying business--hence its dividend--as to put in a stop, you shouldn’t own it anyway.

Question of the Week

Here’s a question I saw several times last week that’s worthy of addressing. Send your question to utilityandincome@kci-com.com.

• I watched the HBO special “Gasland” on the practice of hydraulic fracturing that was very shocking. Are any Utility Forecaster companies exposed?

Hydraulic fracturing, or “fracking,” is a practice used to extract natural gas that’s otherwise inaccessible. Fluid, mainly water, is injected into targeted rock formations, allowing wells to be horizontal as well as vertical. The result is “unconventional gas” mainly from shale is available in quantities scarcely imagined just a few years ago.

In fact, were there enough liquefied natural gas (LNG) export capacity available the US could become the world’s largest gas supplier. The fact that the production is largely trapped in North America is the biggest reason why natural gas is currently so cheap, holding down electricity prices as well.

The vast majority of natural gas production in the US is now done with some form of fracking. Its proliferation, however, has raised concerns about just what is being injected into the ground to produce gas, and what its impact could be on the environment and, by extension, public health and safety.

Despite the frightening conclusion posed by the HBO special, the jury is still out on what, if any, environmental degradation fracking causes. On the one side is industry, which maintains its practices are safe and points to a relative lack of problems in most drilling areas.

On the other are those like conservation group American Rivers, which claims the Delaware River--widely regarded as one of the cleanest free-flowing rivers in the US--is now the most endangered river in the country, due to fracking in the Marcellus Shale region. Residents have allegedly reported everything from a “browning” of local water supplies to actual combustibility. And similar charges have been levied at fracking in Colorado, New Mexico and Wyoming.

I see two different types of exposure here. Water utilities like York Water (NSDQ: YORW) in Pennsylvania could obviously be impacted by higher water treatment costs, should allegations by fracking’s critics prove on the mark. To date, they’re reporting nothing of the sort. But changes in water production costs are always critical to keep an eye on.

Then there are the gas producers, whose exposure is mainly on the drilling cost side. There is no uniform fracking technique used by all nonconventional gas drillers. Rather, different companies mix different chemicals with the water they inject into the ground.

New York State is considering a moratorium on all fracking. But it’s relatively unimportant to shale gas production. And because shale gas is so important to US energy needs, an outright nationwide ban is extremely unlikely. That much was crystal clear from Congressional hearings that followed ExxonMobil’s (NYSE: XOM) announcement that it would merge with XTO Energy (NYSE: XTO) some months ago.

We could, however, see regulations placed on what chemicals can be injected, which would have the potential to drive up drilling costs. That would have an impact on producers, though the costs would probably be passed along in prices paid by consumers and businesses. The stronger the regulations, the more possible it is for drilling to be curtailed, which could hurt midstream asset expansion plans at companies like Enterprise Products Partners LP (NYSE: EPD). On the other hand, these companies don’t build anything without long-term contracts in place. So even here there’s probably not a lot of vulnerability.

This is certainly an evolving issue. But I encourage readers not to get too carried away with potential winners and losers until there are a lot more facts here. And let’s face it; there are a lot of much dirtier ways to produce energy that would be ratcheted up if fracking were ever seriously rolled back. Mountain top mining of coal is one practice that does obvious and extreme damage to water supplies. And the BP (NYSE: BP) disaster in the Gulf of Mexico shows pretty clearly what can happen when a deepwater well isn’t drilled properly.