Safe Sectors for the Coming Year and Beyond

December 12th, 2012
in contributors, syndication

Investing Daily Article of the Week

by Roger Conrad, Investing Daily

Drama and hyperbole are certainly no strangers to the market. And at no time has that been more the case than in late 2012–as the 24-hour news cycle has morphed into an immense infotainment colossus with a political spin.

Every disappointment seems to mushroom into a catastrophe. Every opportunity becomes a once-in-a-lifetime chance to strike it rich.

For more than a decade, I’ve considered it my job in Utility & Income to strip out the drama and hyperbole from developments as much as possible, and just focus on the facts. That’s admittedly a tough task when the consensus is succumbing to emotion and feeding the prevailing momentum. And I wish I could say my analysis has always been spot on.

Follow up:

But to the extent I have been successful, I’d like to credit two things. The first is diversification. The point isn’t to try to minimize the risk of every stock you own, but that of the entire portfolio.

The only way to do that is to be sure that one company’s weakness isn’t enough to sink the whole portfolio. That’s why I never double up on any one investment, and I always advise taking partial profits on overweight positions.

Second, I always focus first on the health of a stock’s underlying business, and its ability to build wealth for investors. As long as a company is fundamentally healthy, market history is clear that its stock will be able to recover from any catastrophe.

I’ve said it before and I’ll say it again. Almost every stock took a wicked hit between the end of the second quarter of 2008 and the market’s subsequent bottom in March 2009. But in less than a year, dividend-paying stocks that had preserved or increased their payouts had fully recovered.

The rebound was even faster following the retreats in early 2010, autumn 2011 and earlier this year. And though we’ve seen some big blows to many companies the past few months–particularly to high-yielding stocks with  dividends perceived at risk–they’ll also recover, as long as their businesses remain healthy.

So how do you know if a company is healthy? There are several key metrics I monitor when it comes to dividend-paying stocks.

One is the payout ratio, or basically the dividend as a percentage of the profits that pay for it. Generally speaking, the lower the payout ratio, the safer the dividend and the more room a company has to increase it.

Investors need to be careful to use the correct measure of profit. For most companies that’s earnings per share, but only after factoring out the impact of one-time events and gains or losses that don’t involve actual cash. For master limited partnerships (MLP) and even many corporations, you have to look at what’s called distributable cash flow, or cash flow less capital expenses needed to maintain the business, taxes and debt interest.

Debt is also an important consideration. US corporate borrowing rates are at their lowest levels ever. But when credit markets tighten, some companies find themselves forced to borrow at loan shark rates. Those with significant refinancing needs may have to cut dividends as well.

Capital-intensive businesses require companies to carry large amounts of debt. But even with interest rates this low, I’m still more comfortable with companies that have minimal near-term borrowing needs–preferably none between now and the end of 2014. I also prefer enterprises that weathered 2008 with minimal damage. They’ve already proven their ability to take the worst the market throws at them.

The surest sign a company meets safety standards, however, is qualitative, not quantitative. Simply put, the more essential the services or products a company provides, the more reliable its revenue is in all environments–and the more investors can count on its earnings, balance sheet and dividends to remain secure even during the worst market turmoil.

And now we come to what’s been the real secret to thriving in the stock market since the 1990s bull market came to an end: buying and holding essential services companies.

Electric, gas and water utilities don’t generally lead the pack during good times. And while some power utilities did well in the 1990s by attempting to grow with the deregulation experiment, most came to regret it when Enron collapsed suddenly in late 2001.

Enron’s fall was followed by the power sector’s worst shakeout since the Great Depression. And by early 2003, some two-dozen industry companies were either in Chapter 11 or perilously close to it.

What’s followed since then, however, is a historic deleveraging by companies that have also cut operating risk and repaired frayed relations with regulators. While US banks failed in record numbers in 2008, regulated power, gas and water utilities sailed through the crisis without so much as a major dividend cut.

Now nearly four years later, they’re stronger than ever financially, having taken advantage of record-low corporate borrowing rates to eliminate near-term maturities and slash interest costs. And many companies have been able to invest heavily in their networks, simultaneously improving reliability and boosting earnings by adding rate base.

To be sure, we face some mighty challenges now. The rancor between Democrats and Republicans hasn’t diminished since the election, when US voters made clear they wanted the parties to work together to solve problems, rather than give one side all the power. That’s raised doubts about a potential fiscal cliff knocking the wind out of the US economy next year, and taking down the rest of the world with it.

Taxes are also going to rise next year, and perhaps even higher if there’s no deal on the budget. That’s convinced some investors to run and hide from dividend-paying stocks, even though there are few alternatives that provide anything close to a decent income stream.

One big reason I’m not fleeing is I have secure positions in dividend-paying essential services stocks, both as recommendations in my advisories and in my own personal portfolio. They proved in 2008 they can take a punch. They’re stronger than ever now. And with investors abandoning even their safest stocks, there are more sector bargains now than in many months.

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