Taking Stock

September is back-to-school time. It’s also a great opportunity to re-examine your portfolio and strategy to ensure you make the most of what’s often the year’s most profitable quarter in the markets.

October has a bad reputation with many investors. Ironically, it’s been a good one for utilities and other income investments more times than not. For example, October marked the bottom of the 1990 selloff for utilities–and indeed much of the broad market–as the world considered its response to Iraq’s invasion of Kuwait. The 10th month was also a turning point for the 2001-02 Bear Market, the worst utility stock collapse since the Great Depression.

If historical patterns hold, the ninth month is the one we have to watch out for. And with falling interest rates pushing up prices of utilities and other income investments, there’s room for disappointment this month as well.

Looking ahead, however, the precedent is very good for a continued rally for income plays. And that case is helped considerably by the recent downturn in interest rates, notably the dip in the benchmark 10-year Treasury note yield to a current level of around 4.78 from a high of 5.3 percent just a few months ago.

As my colleague Neil George has noted, there are some worrisome signs regarding inflation pressures that appear to be creeping in. His view is we’ll continue to see an inversion of the yield curve, a relatively rare condition under which shorter-term paper yields more than longer-term paper. Should that be the case, income investments like utilities will almost surely hold their own and possibly will gain ground, even if inflation creeps higher.

As I pointed out last week, prices of income investments across the board are at basically the same high levels they were last year, when the benchmark 10-year yield was around 4 percent. That leaves a lot of room for disappointment, whether the economy slows and brings down inflation or the latter accelerates.

All else being equal, seasonal strength should help high-quality stocks, preferred shares and bonds. But there’s a lot that could change that equation going forward.

No company with a healthy, growing business will lose much ground for long, even in a worst case. But investors who buy at any price may wind up underwater for a while, should, for example, interest rates continue to rise.

The best way to avoid getting burned with income investments is to stick to the buy prices designated in Utility Forecaster and the Personal Finance Income Portfolio. These prices have been set with business fundamentals in mind. A company trading below its buy price is worth buying on the basis of the growth of its underlying business. Its shares may push higher for a time if interest rates head lower, or they may slump if rates rise. Over time its value will appreciate from that buy price, adding steady capital gains to generous dividends.

Some subscribers have groused in recent weeks that more than a few recommendations have risen well above current prices. And many have no doubt simply bought in anyway, regardless of the price.

To them, I have to point out that many of these same recommendations traded well below the target buy prices for weeks or even months. There was plenty of opportunity to buy them at a low valuation, and odds are there will be again.

As long as you buy stocks in companies with healthy, growing businesses, you’re not going to lose much ground even in a worst-case macro environment. But you can lose money in the near term if you buy too high. Patience is a far better road to follow. And if you absolutely have to buy something now, pick one of the recommendations trading below its buy target.

Gusher In The Gulf

As is usually the case, the days surrounding the Labor Day holiday are notoriously light on major corporate developments. The exceptional story this time is the purported discovery in the deepwater Gulf of Mexico of a giant field or series of fields that may contain as much as 15 billion barrels of oil and gas reserves.

If those lofty projections prove true, it would be the biggest discovery in US territory since the North Slope of Alaska more than a generation ago. It would also increase reported total US reserves of oil and gas by as much as 50 percent.

The biggest beneficiaries of the deal appear to be Chevron (NYSE: CVX) and its smaller partners Devon Energy (NYSE: DVN) and Statoil ASA of Norway. The trio has announced the successful test of a 5.3-mile deep well; among the world’s deepest, the well is estimated to have cost more than $100 million. They’re now considering moving ahead with development and could commence new production as early as 2010. And a host of other companies may join them in redoubling their efforts.

The exploitation of the North Sea in the 1970s enabled the oil industry to break the grip on supply held by the major global producing nations in OPEC. With prices low throughout the ’90s, the incentive to pursue new opportunities for production was very low. But as prices have risen since, Super Oils have returned to the goal of finding another “North Sea” to reduce dependence on the increasingly unstable Middle East, as well as increasingly demanding producer nations like Russia and Venezuela.

It’s far too soon to tell whether or not the deepwater Gulf will prove to be the Holy Grail this time around. And it’s best to be skeptical of the hype surrounding this story, which appeared on the front page of today’s Wall Street Journal.

Even if the most optimistic projections prove true, meaningful new supply won’t be coming on the market for another four to five years. That leaves plenty of time for either further instability-related supply disruptions or for existing fields to run down. Several well-known analysts have postulated that key fields in Saudi Arabia and Mexico may be winding down.

In addition, deepwater Gulf production is unlikely to bring down oil and natural gas prices in any meaningful way, even when its output begins to come on line. For one thing, even top-end projections don’t put the new find anywhere close to the size of the Saudi or Mexican fields. It’s also very expensive to drill lengthy holes so many miles below the surface of the waves, new technology notwithstanding.

Instead, like the Canadian oil sands, deepwater Gulf production will depend on relatively high energy prices to be fully economic (i.e., worth the while of the Super Oils and their allies to spend the capital to pull it out). Having the additional supply should insulate the developed world somewhat from political shocks to supply. But if prices should come off, that output will likely drop off as well. In effect, the more the world uses the bitumen output of the Canadian oil sands or whatever comes out of the deepwater Gulf, the more locked-in high energy prices will become.

The near-term impact of this story is very different from these long-run realities. The price of oil has already come down on the news of the discovery, and it may fall further still if investors become worried enough. That, in turn, could hit more leveraged areas of the energy patch, and it may even trigger a selloff in the stronger energy producing stocks if sentiment gets frothy enough.

This, incidentally, is one reason I view purchases of oil and gas producing properties with a great deal of skepticism now. I don’t want to own a producer that I think is paying too much for reserves and production now. There’s simply too much downside if there’s a severe near-term correction.

All that notwithstanding, this is not the end of the road for the energy bull market. At this point, even if the deepwater Gulf does ultimately become the North Sea of this generation–which will only be possible if production costs come off sharply and reserves wind up exceeding even today’s most optimistic projections–we still have years to wait before any of its output comes to market.

Meanwhile, we still haven’t seen anything remotely resembling the conservation, move to alternatives or demand-crushing global recession that killed off the ’70s energy bull. Put another way, this isn’t the sell signal for all your energy stocks.

It is, however, time to consider what energy stocks you’re in. If the deepwater Gulf does become a major factor in energy markets, there are clearly going to be some major winners, as well as some big time losers.

I’ve often recommended Chevron as one of the surest, lowest-risk energy plays. And this discovery is just another reason for those who don’t already own it to buy and lock it away, despite the surge in price today. Infrastructure is also important, and few players have a bigger potential stake in that arena than limited partnerships Enterprise Products Partners (NYSE: EPD).

As for what to avoid, the simple answer is the hype. Every resource boom in memory has produced incredible winners. But every one has also left a lot of people holding the bag with stocks they were sold on, but which wound up containing little more than the deed on some moose pasture.

My primary advice is to avoid most small stocks in energy, just as you would most penny mining shares. There are going to be far more losers than winners in this group. And unless you have some inside knowledge and are able to get in early (read: ahead of when a stock is promoted to the general public), you’re a lot more likely to wind up in the losers camp.

The problem is with a small stock you’re betting on more than the trend in energy. You’re betting management can make its business strategy work–certainly no given even in the strongest environment–and that you’re getting in at a straight-up price. In contrast, bigger companies are basically bets on the primary trend alone–you won’t get beat on something you didn’t foresee, or, worse, the knowledge of which has been kept from you.