Betting on Recovery

Never underestimate the small mindedness of politicians: That looks like the lesson of the week for investors. The morning after the biggest bank failure in history—Washington Mutual—Washington is still squabbling about the details of how to sort out the mortgage securities mess and unfreeze the US financial system.

Wall Street’s bear market is now nearly 15 months old. And as weakness in the financial system worsens, the more likely we’re going to see further downside. Daily swings of several hundred Dow points have become almost routine, as stocks of blue chip companies so far unaffected by the crisis are bobbing up and down like penny stocks.

The reality is, as of right now anyway, we have a sitting president who is struggling to persuade members of his own party to respond to what he (correctly) calls a crisis. My gut feeling is still that some kind of plan will be enacted, and we’ll avoid a full-scale run on Wall Street. But it’s more critical than ever for all of us to take stock of where we are and where our potential exposure lies in case the worst-possible scenario unfolds.

In times like these, a sane fear is an investor’s best friend. Bear markets aren’t trading abstractions. They’re fueled by stress tests on both the overall economy and individual companies. And investments that fall prey to them—whether they’re common stocks, preferred stocks, bonds or mutual funds—can literally become graveyards of capital.

Throughout this bear market, I’ve consistently advised three things. That’s the strategy I continue to advocate for investors.

The first is to stick with companies whose underlying businesses continue to post healthy numbers in the face of the stress tests: the credit crisis, the weakening US economy and high raw materials prices. This has basically involved a careful analysis of results when quarterly earnings are released, the next batch of which are due out beginning late next month.

My second rule has been to dump any common stock, preferred stock or bond-backed company showing weakening numbers. I’ve so far called 10 of the last 12 disasters. But again, weakening earnings numbers are the surest sign of a potential blowup—which is infinitely worse than normal bear market damage to an otherwise strong company.

A stock’s price may fall after a disappointing profit report. But if the big picture is getting worse, the risk is high that things will continue to worsen for the stock. The worst losses in any bear market come from such situations, and that’s just not where we want to be. Selling is always the best course of action.

Finally, I’ve advised being very cautious about investing new money, even in my favorite companies. If you’ve been buying and holding my recommendations, you have plenty of exposure to this market and its ultimate recovery. Incremental investing in a few targets is always a good idea, particularly if you’re using a dividend reinvestment plan. But there’s no great rush to buy a lot of new positions now.

In addition, I continue to strongly advise against averaging down, better termed “doubling down,” in a falling stock. As the blowup of Constellation Energy showed this month, bear market stress tests can show up in places you never suspect. And like that surprise leak that appears in the basement during a particularly heavy rain, these stresses can hit hard and fast.

As readers know, I’ve never advocated selling anything solely based on rumor or even a falling share price. In my experience, people who use such automatic rules more often that not wind up getting whipsawed out of good positions at lousy prices, only to see their sales rebound.

If an underlying company is truly weakening, it should be sold, but that’s going to show up in the actual earnings numbers. Occasionally, something comes apart between earnings releases, and you have to react. But even in a market like this, there are almost always warning signs in the previous profit report. Those are the numbers to pay attention to, particularly when you’re talking about dividend-paying stocks, which always recover as long as their dividends stay solid.

Thus far in this bear market, this cautiously optimistic strategy has worked relatively well at avoiding blowups. But not even the highest-quality regulated utilities have proven immune from selling, and even Treasury notes have come under pressure on some days. Moreover, two of this market’s stress tests appear to be ratcheting up: the credit crunch and weakening US economy. That could make for some weak third quarter earnings.

The fact that we have challenges isn’t in dispute. My view, however, is still that it won’t pay for income investors to try to anticipate weakening results for companies that have weathered the storm thus far. In fact, odds are strong that a company posting solid first and second quarter numbers will also record reasonable third quarter numbers.

The economy has weakened markedly in some areas. Financial stocks, for example, are obviously in for more writeoffs as the housing market continues to sink. Advertising has apparently slipped further in the past few months, and consumer-focused companies--such as retailers--face more risk as slowing growth takes its bite and discourages spending.

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All of these industries were already feeling the bite in prior quarters. And despite the severe turmoil in the financial sector, there hasn’t been much to drag down companies operating in industries that have continued to grow this year.

In my view, the biggest point of third quarter vulnerability for earnings is energy and raw materials. Prices of everything from oil and gas to copper and agriculturals have come down since the end of the second quarter. Most producers systematically lock in future prices for output by hedging and will likely dodge the worst. But there will be an impact and, in the case of dividend-paying fare such as oil and gas trusts and limited partnerships (LP), the price may be lower distributions.

The good news is two-fold. First, commodity price declines and the itinerant risk of dividend cuts are well priced in for sector stocks. An actual cut may take prices down further initially, but the worst has already happened.

Second, as we saw with oil’s bounce over the past week, prices are low for one reason alone: the risk to the global economy posed by the weakness in the US financial system. Anytime those fears subside, prices snap back with a vengeance.

The US financial crisis has now reached a critical phase. The executive branch of government has proven itself ready, willing and able to move quickly to provide liquidity to the system to head off disaster. US Federal Reserve Chairman Ben Bernanke cut his teeth in economics by studying the Great Depression and has been able to avoid the mistakes made by the Central Bank at that time. Treasury Secretary Henry Paulson has also proven his mettle, providing strong global leadership as the crisis worsened.

With an election year looming, however, Congress and the two leading presidential candidates have provided a great deal more uncertainty. Paulson’s proposal for a $700 billion fund to buy distressed mortgage assets has been met with outright hostility in some quarters, deep skepticism in others. In fact, many are calling it dead.

Not surprising, many of the most vociferous critics have come from the president’s own party. Many consider government action to stabilize financial markets as a reversal of the deregulation/small government ideology that’s prevailed since President Reagan and a dangerous slide toward socialism.

Last week, I posited another view: that the banking system’s turmoil mirrored that of the utility industry earlier in the decade. In both cases, a formerly staid sector saw decades of regulation lifted. The result was a focus on growth and risk taking that ultimately collapsed when industry conditions worsened.

For power companies, it was a tapering off of demand and electricity prices, accompanied by the surprise collapse of its former poster child Enron in an avalanche of scandal and debt. For banks, it was the end of the bull market in housing prices, which exposed a mountain range of shaky loans that collapsed on the innocent and guilty alike.

The utility industry dug its way out and strengthened again. Management cut debt and operating risk, focusing on running core regulated utility businesses and repairing relations with regulators.

The industry today is decidedly more regulated than that of the late 1990s. In fact, a growing number of the states that had originally deregulated have gone back to the regulated monopoly model. Companies must once again ask regulators for rate increases to pay for infrastructure projects and cover operating costs. But unlike during the ’70s, ’80s and early ’90s, officials and executives are again working together to make needed investment and keep costs low.

There are challenges ahead, such as paying for what’s likely to be legislated reduction in carbon dioxide (CO₂) emissions. But so far, the new regulatory compact is working. And for the first time in decades, companies have been able to stabilize and even boost credit ratings, even as they boost dividends.

Even including the recent weeks’ selloff, utility stock prices are still multiples of where they were at the industry’s nadir in late 2002. Even the two dozen companies either in Chapter 11 or close to it back then have since recovered, with the exception of the busted Enron. And even Enron’s shareholders have gotten something back, courtesy of a now-resolved lawsuit.

Financials, of course, differ from utilities in many ways. Like utilities, however, they’re absolutely essential to a functioning economy. And radio pundits’ blather notwithstanding, the federal government has no more interest running the financial system to perpetuity than it did in nationalizing the utilities earlier in the decade.

The Wild West days are over, just as they are in the utility industry. And tougher regulation is coming, no matter who wins the White House. In this regard, President Bush’s speech to the nation this week really does mark a watershed. Gone was the staunch small government/deregulation-focused rhetoric of the last seven-plus years. Rather, the president talked about the federal government as the only institution large enough to tackle the problem. And he expressed support for regulatory overhaul as well as eliminating “golden parachutes” for executives helped by the government.

Those comments didn’t please the most ideological of his party. Rather, they do represent the triumph of pragmatism. And whether there’s a $700 billion mortgage cleanup plan passed or not, it’s going to set the tone for the future financial system, just as it did in the utility industry earlier in the decade. The de facto federal pledge to defend the value of money-market funds—as deposits are ensured by the Federal Deposit Insurance Corporation (FDIC)—is a giant step in that direction. And many more will be taken in coming months.

Again, that won’t make everyone happy, particularly on the right and left of the major parties in Congress. But it will ensure the financial system eventually recovers.

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In the near term, of course, what happens to the market and financial system hinges heavily on whether Washington can put aside election-year politics, political vendettas and other nonsense and pass some kind of plan to build in some stability for the mortgage securities market. It won’t be the last word on this crisis. But it will bring some stability to an industry that desperately needs to become a good business again.

I’m no political forecaster. But I’m willing as ever to bet that America will survive, and value will ultimately reassert itself in the stock market.

Until Washington puts aside its differences, we can look forward to a lot more turmoil in the days ahead. That’s another good reason to hold at least a little bit of the ultimate disaster insurance: Gold. One good way to play is major miner Goldcorp (NYSE: GG), which Yiannis Mostrous and I have been recommending in our hard assets advisory, Vital Resource Investor.

My final comment this week on the unfolding financial crisis concerns credit raters such as Standard & Poor’s and Moody’s. Here, too, the parallels with the utility crisis of 2001-02 are striking.

Then, as now, the raters completely missed the building catastrophe. Long-time Utility Forecaster readers may remember that Enron—the literal epicenter of the utility crisis—was rated BBB+ the day before it filed Chapter 11. That surprise crackup then triggered an unprecedented wave of credit rating downgrades industrywide, which did exacerbate the crisis even in companies that weren’t caught up in the meltdown of energy trading.

Dominion Resources shares, for example, were pushed into the low-30s, solely because S&P threatened to cut the company’s rating to junk if it didn’t issue some $2 billion in equity. As it turned out, the company wound up issuing the stock in the low 30s, less than half the share price of a few weeks earlier. The shares then proceeded to rebound sharply to their former levels as the company’s so-called “liquidity crisis” passed.

Having completely missed the meltdown, the raters were then extremely slow to raise credit ratings as the recovery ensued. Despite Herculean efforts to slash debt, dump riskier operations, repair relations with regulators and refocus on core businesses, ratings barely budged. I made that point in the January 2007 issue of Utility Forecaster. Since then, ratings have risen somewhat, though arguably not really enough given the reduced risk.

In this crisis, the raters clearly missed the underlying weakness of financial firms. More important, however, they missed the vulnerability of collateralized debt obligations (CDO). Predictably, after the recent string of bankruptcies and bailouts, they’re moving into overdrive, slashing ratings across the board. And just like what happened in the utility industry in 2002, the ratings cuts are creating their own crisis of confidence, squeezing liquidity of otherwise solid companies.

Last week, I highlighted the meltdown of Constellation Energy as an example of an otherwise strong company forced to do a merger deal to shore up its capital base, largely in response to the threat of a ratings cut. In my view, the buyout price of $26.50 a share in cash is likely to be raised, as the financial industry crisis subsides and the credit squeeze loosens up.

For example, though initially rebuffed by Constellation’s board, Electricite de France is still reported interested in a counterbid. Its last offer of $35 a share was primarily rejected because it was less sure than Berkshire Hathaway, owing to US regulations forbidding foreign-owned companies from wholly owning US nuclear plants. But a lessening of credit concerns could well persuade it to reopen negotiations. And in any case, management is already under pressure from shareholders and Maryland regulators—as well as the state’s governor—to do just that.

Following the pattern of the utility sector meltdown, raters are likely to keep the pressure on financial companies for some time. In fact, I would expect to see more ratings cuts put more pressure on more companies before this plays itself out.

All this of course begs the question: What good are the rating agencies to investors? I’ve tracked ratings in Utility Forecaster over the years for three major reasons. One, they’re still the only game in town when it comes to rating credit quality, which makes them a very good indicator of a company’s cost of credit.

Two, because raters have been so conservative with utilities since 2002, the ratings tend to represent a worst case scenario for holders of a company’s stock, bonds and preferred shares. That fact hasn’t been lost on the market, as even junk-rated utility securities have vastly outperformed most bonds.

Third, raters do often provide interesting insights in the research presented, just as brokerage reports do. You don’t have to swallow the overall opinion to get some good information that’s not available elsewhere.

Looking ahead, that’s the way I’ll continue to view ratings for utilities, as well as other companies. And just as the opinions on utilities have become more worthwhile since that sector’s meltdown, so ironically should they be for the financial services industry as we cycle out of this mess.

Put simply, ratings agencies are what they are: for profit corporations. They make profits from fees, which in turn depend on companies being willing to be rated. Unless they’re nationalized—which I would view as highly unlikely—that’s the way they’re going to operate.

Again, we can get some things out of them. But ratings agencies’ opinions are no substitute for doing your own research or, more importantly, for making up your own mind.

Note that subscribers can access the October issue of Utility Forecaster at www.utilityforecaster.com beginning Saturday morning. This month’s topic: betting on sector merger activity, which appears to be reviving a bit here in late 2008.

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