Real Change

Change is the watchword of this presidential election season. The fact that the candidate of the party currently out of power—Democrat Barack Obama—would talk about shaking things up is no great surprise in any campaign. This time around, however, even ruling party candidate John McCain is trying to present himself as an agent of change.

With the US economy apparently still sliding, the stock market tumbling and inflation rising, change-focused messages are understandably popular. And it’s only natural that politicians would respond.

Real changes that truly impact peoples’ lives and create real economic wealth, however, always draw their strength from the private sector. Government certainly has the influence to steer developments in one direction or another, using the power of the purse as well as regulation. And government-sponsored or subsidized research has been responsible for many--if not most--of the breakthrough technologies now shaping the 21st century economy.

Ultimately, however, changes have to make economic sense to a large number of people in order to successfully permeate the culture and become the status quo. Government can help or hurt, but it can’t do all the lifting by a long shot.

Similarly, most developers and early adapters of truly new technologies are never profitable. Only a tiny fraction of ideas with great potential ever see the light of day. Instead, the vast majority wind up in the wrong hands at the wrong time in the wrong way. And by the time they do see the light, they’re co-opted by larger companies who use them to become more profitable than ever.

One of my favorite market maxims is to never confuse a breakthrough technology with a great stock. The example of what happened to Voice-over-Internet Protocol (VoIP) pioneer Vonage is still one of the best cases.

Over the past few years, VoIP has become the technology of choice for communications providers the world over. Pure play Vonage has picked up its share of subscribers. But it’s still no where close to being profitable, and its shares are now barely above a dollar, a fraction of the initial public offering (IPO) price and less than half of its 52-week high. Although VoIP has been a huge winner, Vonage has been a miserable failure.

On the other hand, companies that turn a major change to their benefit do create economic wealth. The results don’t always show up right away in their share prices. Over time, however, a business with inexorably growing profits and sales will push a successful company’s stock higher, creating wealth for shareholders as well.

This relationship between stock prices and private-sector change agents that create economic wealth is critical to remember in times of market turbulence. As I’ve written before, my view is this bear market began 14-plus months ago, when the credit crunch first started to bite the US financial system.

Since then, we’ve seen several periods of intense selling followed by mild recoveries and then more selling. Some sectors have fared better than others. And many companies—particularly in infrastructure-related industries—have managed to stand up to the economic stress tests underlying this bear market. Those are mainly high prices for energy and other raw materials, weakening growth particularly in the US and market conditions that have made it very difficult to raise capital at a good price.

Even the “winners” of this environment, however, have lost value. And selling has definitely picked up the past few weeks, as evidence of slowing growth has begun to show up in other nations. Moreover, this week’s weaker-than-expected employment numbers have stirred worries that things are going to get a great deal worse here in the US, before they get better—despite the US government’s relatively sunny figures for overall growth in GDP.

In such an environment, many investors throw in the towel, and it’s not hard to see why, with virtually everything in their portfolio losing ground. Some respond by selling their “losers.” Usually, these are stocks and bonds that show the biggest losses in the individual’s portfolio. Some might be real meltdown situations with deteriorating business fundamentals. All too often, however, they’re just stocks the investor purchased at a high price that have come down with the market.

There may be nothing wrong inside, and the company may in fact be posting strong earnings and increasing dividends. All the investor sees, however, is his or her brokerage statement with a big negative number. And the emotional satisfaction of dumping a stock--or even an investment advisor--perceived to have cost them money is too compelling to pass up.

This, unfortunately, is how many investors get whipsawed out of good positions in a bear market. There is a worse bear market sin: sticking with companies whose businesses really are falling apart in the face of the bear market’s underlying stress tests.

Those stocks, bonds and funds are what can really blow a hold in portfolios. Money always flows back to stocks backed by healthy businesses, once the market mood shifts to a more positive frame of mind. But most of the real blowups never come back. And even those that survive may take years to pare back losses that could have been avoided by simply selling once evidence of business weakness came to light.

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Avoiding the real blowups is one reason I focus so strongly on earnings reports and Securities and Exchange Commission (SEC) filings such as 10-Qs and 10-Ks. For all their faults, these are still the best places to go to assess a company’s underlying business health. And although they certainly can’t forecast future business conditions, they are the best indicators of whether or not a company is on solid ground or if there’s potential for a real meltdown.

My view is investors always want to err on the side of caution. Any company is suspect if it’s not earning its dividend with distributable cash flow. Likewise, declining sales and operating margins (operating income as a percentage of revenue) are never a good sign. Nine times out of 10, I’ll recommend selling.

On the other hand, bear markets are the ideal time to buy stocks of some companies: those creating economic value, particularly if their ascendancy is tied to some inexorable change gripping the wider economy.

Bear markets are bear markets because more people sell more than they buy. Selling brings down stock prices, and the victims become better values.

The most profitable investment calls I’ve ever made for subscribers—as well as for my own account—have always been when overall market conditions are bad. And I’ll wager the same is true for most of you. The picks haven’t been anything fancy, just companies creating economic value whose stocks are depressed because of poor market conditions.

So what are the big changes occurring now that will create real economic wealth in the years to come? One area is definitely communications, particularly of the wireless variety.

When this bear market began, the consensus on Wall Street was that communications companies’ days as recession resistant were in the past. The assumption was that consumers and businesses would cut their spending on advanced services from broadband to wireless, while the multi-year trend of basic copper phone line disconnections would accelerate. The result, it was assumed, would be falling sales and earnings for communications services providers across the board.

These forecasts have surfaced immediately prior to every earnings season since mid-year 2007. And each time, communications companies in general have reported numbers directly contradicting the thesis.

To be sure, some elements of these businesses have shown signs of being affected by the slower US economy, notably higher writeoffs of bad debt expense and a slowdown in the growth of wireline broadband connections. Overall numbers, however, have remained robust. In fact, earnings growth has actually accelerated for the industry’s Big Three: AT&T, Comcast and Verizon Communications.

In the case of AT&T and Verizon, the key has been wireless growth. Both have continued to add new customers, more than a few at the expense of still-floundering Sprint Nextel. But the real growth has actually been in revenue per customer, thanks to sales of a growing stream of data services from music downloads to texting. Data revenue growth at both companies was close to 50 percent in the second quarter.

Comcast’s growth numbers are arguably even more impressive since its efforts in wireless are more in the unproven development phase, namely the startup WiMax venture with Clearwire and Sprint. Rather, it continues to add revenue generating units by upselling its basic cable television customers to digital cable, broadband Internet and VoIP-based telephone service--proof the wireline broadband business is also robust in the face of slow growth.

It may be that the US economy will slow enough to put a dent in broadband and data growth. But the message is crystal clear for anyone willing to listen: Something bigger is going on here than a mere economic cycle.

Simply, global demand for connectivity is accelerating and consumers are more than willing to pay up for better and faster service, despite an overall weak environment. In fact, the greatest growth in connectivity is still ahead, as a new generation of teens, 20- and 30-somethings grow up in an age where instant information is not only desirable but critical to functioning in society.

Moreover, the trend is in no way confined to these shores. China, for example, is now rumored to be mulling a rapid shift to a 4-G wireless technology called Long-Term Evolution (LTE). If it’s successful, the country will leapfrog the 3-G systems now being rolled out in most of the developed world, giving it the fastest and most effective wireless data network in the world. That, in turn, will force other countries to upgrade, lest they fall behind.

LTE also has the advantage of bridging the divide between the world’s primary two rival wireless technologies: code division multiple access (CDMA), which is used primarily in the US, particularly by Verizon, and Global System for Mobile (GSM), which is used everywhere else. LTE development is particularly attractive to Verizon and its partner in the US, Vodafone. Verizon Wireless currently runs on CDMA, while Vodafone is 100 percent GSM. Linking up with LTE will seamlessly connect the two, opening up a whole new array of opportunities for growth.

Like all enterprises, big communications companies certainly do face threats. Despite the extremely dismal track record of telecom upstarts such as Vonage, there still seems to be no shortage of investors willing to pour money into small companies that try to compete.

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Regulation is another area of concern. The US Federal Communications Commission (FCC) is currently controlled by a 3-to-2 Republican majority, thanks to having Republican President George W. Bush in the White House. By and large, their decisions have supported industry growth and profitability, from approving mergers to reducing regulatory red tape.

An FCC appointed by a Democratic president, however, could have different ideas. Odds are things won’t be too much different in the final analysis. But the uncertainty is one reason Verizon is rushing to complete its acquisition of Alltel from a private capital consortium by the end of the year, which will make it the largest wireless company in the US.

The important thing, however, is the long trend is for ever-greater connectivity. That spells expanding business for communications providers, as well as for selected equipment and technology companies such as Ericsson.

Another area where the growth trend is trumping the macro picture—at least on the earnings front—is electric power. Power sector capital spending surged to $80 billion in 2007 and is on track to be higher still this year, as the industry ramps up to modernize aging network infrastructure and meet an estimated 30 percent boost in overall demand by 2030.

As I’ve written here, meeting these needs is expected to cost more than $1.5 trillion in the US alone by 2030. The key for individual companies will be recovering that investment, either through the regulatory process or in unregulated markets.

The last major construction cycle for electric companies was during the 1970s, which notably included the construction of the current fleet of nuclear power plants. Some companies were able to complete their projects relatively on time and close to budget, thereby enabling them to recover and earn a return on their investment.

Others, however, suffered huge delays and cost overruns, and were punished by regulators with massive writedowns. Public Service of New Hampshire—now a part of Northeast Utilities—was actually forced to file bankruptcy because of the cost of delays in completing the Seabrook nuclear power plant.

I’m not expecting anything different this time around. The good news is utilities are recovering their capital spending pretty much across the board. That includes formerly hostile environments such as Nevada, where recovery in rates of the ongoing construction investment actually lifted Sierra Pacific Resources’ second quarter earnings by 25 percent. And that was despite the impact of noticeably slowing customer growth in its service territory.

In fact, the current regulatory compact is arguably the best for the industry since the 1950s and ’60s. Unlike during the rancorous times of the ’70s, ’80s and ’90s, officials and utilities are working together to do better long-term planning to simultaneously hold down rates and keep utilities healthy.

That compact, however, will be severely tested by the level of capital spending needed to upgrade America’s power system to meet the needs of the 21st century economy. Moreover, the current weak state of the US economy has made rate hikes considerably less politically palatable than earlier in the decade.

The bottom line is there are almost certainly going to be casualties from this construction cycle, just as there were in prior ones. Companies that are able to earn a return on the needed investment will prosper. But those that can’t are headed for potential financial ruin, and their customers will suffer the penalty of higher rates long term as weakened companies are unable to make needed investment.

Separating the good from the bad in the power industry hasn’t been so important the past several years, with regulators everywhere in a cooperative mode. But it will be critical going forward and the key difference for investors between cashing in on the long-term trend of power system spending and getting run over by it.

Power company stocks have been taking a hit across the board, particularly in the past several weeks. Some investors seem to have decided that earnings will indeed finally be affected by the stress tests of a weak US economy, rising raw material costs and inhospitable capital markets.

As I wrote in the September issue of Utility Forecaster, that weakening hadn’t happened as of second quarter earnings, which were mainly very robust. The good news is the potential for future deterioration is now priced in. That limits downside risk from here. And if the macro environment should stabilize or improve, we’re going to see a lot of upside.

Summing up, this is a good time to bet on inexorable long-term trends such as the rising demand for connectivity and electricity. But buyers must be willing to research and buy only very strong companies, as well as ride out a lot more volatility and dump anything that weakens during stress tests. Those willing to do that will be able to ride this bear market to big profits in the recovery that will inevitably follow.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat if the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Roger Conrad, Gregg Early, Neil George and Elliott Gue.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.