Yachtsman Investment Article


December 4, 2008


Seeking core investments in recession resistant businesses with sustainable yields providing hard to attain passive income with some degree of security and safety is the objective of every retired and conservative income oriented investor. In this currently dismal recessionary and deflationary economic environment, essential service businesses such as electric utilities and power generation, natural gas, water and telecommunications can provide the income and some degree of safety for longer-term investors. In fact, given the nature of the daily fundamental data facing investors, these essential services may be appropriate for all investors seeking some degree of stability.  


Factory orders for November fell at their most dramatic rate since July 2000. Construction spending fell by a larger than expected 1.2 percent in October and the key Institute for Supply Management (ISM) monthly index of manufacturing activity fell to just 36.2 in November, the worst reading since May 1982.

Meanwhile, the four-week average of initial unemployment insurance claims hit its highest rate since December 1982. The Non-Farm Payrolls number dropped 333,000 as the unemployment rate rose to 6.7%. Compnies like AT&T announced the layoff of 4 percent of its workforce while other major companies have made equally large cuts in their workforce, particularly in the financial service sector. Clearly, the fear of losing jobs is the key reason consumer spending is below year-ago levels,

The National Bureau of Economic Research (NBER) has now proclaimed the US economy has been in recession since December 2007. The NBER’s survey is widely considered the final word in  determining the broad and precise group of measurements used to confirm such an economic downturn and the finncial crisis is obviously exacerbating the downturn.

Their news release confirmed that the US, if not the economies around the world, are headed for a very rough fourth quarter and 2009. The typical post-World War II recession has lasted from six to 18 months, which means we are in the middle innings for continuing economic difficulties for many months to come. The financial crisis has intensified investor fears while another round of selling includes even the strongest companies with no credit problems or liquidity concerns. We are in a bear market and rallies can be sharp but usually brief creating an even more treacherous market than usual. Safety and capital preservation remain the watchwords for this market. 

Additionally, it is apparent, at least for the moment, that oil prices have become the proxy for economic growth expectations. When sentiment favors a resumption of global growth and China's resurgence, oil prices rise along with infrastructure and agriculture. Conversely, fears of a deeper and continued recession invoke a drop in oil prices and a pull back in commodities and their stocks. Oil prices have now fallen into the low to mid-40s, more than $100 a barrel off their mid-summer highs, and despite winter temperatures across the country natural gas prices have sunk to below $6 per thousand cubic feet.

Importantly, shares of the essential services companies including power, natural and propane gas, water utilities and the best of breed telecommunications companies have held their own since the bear market’s mid-summer 2007 plunge through early September. During the past three months, the depth and extent of the financial crisis drove their stock prices down along with everything else as issues of financing and credit availabilty have affected all compnies in all sectors. 

However, the necessity of demand for these services, along with significant dividend increases, have provide substantial support for these essential sectors during this ongoing recession and bear market. The nature of these businesses and the products and services they provide establish them as solid core positions for investors with longer-term horizons or those seeking income.   

More importantly, there have been no dividend cuts among major power, gas or water utilities. And aside from a clearly embattled Sprint (S) there have been no telecommunication dividiend cuts. I expect the major telecommunications companies to increase their dividends as cost cutting and layoffs provide additional capital. In light of the paltry dividends and overbought nature of the Treasury markets, these dividend income streams become increasingly attractive. 

Only takeover candidate Costellation Energy (CEG) admitted the need for greater capitalization and Warren Buffet's Berkshire Hathaway (BRK.A) quickly seized upon the opportunity to provide a massive cash infusion that resolved the liquidity concerns and created a rival takeover battle with 9.9% share owner Electricite de France (ECIFF). The bidding war for Constellation demonstrates the continuing demand by private equity and existing power producers for ownership of added electric power capacity and distribution. 

The essential service sectors continues to outperform in the current recession. While we may see some lower revenue and earnings in the fourth quarter and well into 2009, thrie dividends as a percentage of earnings are less than 70 percent on average for the electric and natural gas sectors. Even based on the lowest current street projections for 2009 earnings, their payout ratio is still only about 65 percent. Figures for the water companies are equally low and communications sector payouts are only slightly higher at 76.6 percent based on the lowest earnings estimates for 2009 profits. 

As a result, essential servives companies can provide some degree of confidence for the longer-term and income oriented investors as current payout rates are covered by a wide margin and provide further security for their dividends. Yields on utilities now stand at the highest levels since the 2002 bear market. They average more than 6% for energy utilities, 5% for the best of breed in the telecommunications sector and 4% for water companies. Yields in select natural gas issues, and particularly those in the gas storage and transportation area, can far exceed even these very generous yields in an environment with a 2.6% 10 year Treasury.

Unlike in 2002, when over-leveraging and over-building created a huge oversupply of power and communications capacity (leading to the collapse of Enron and Worldcom) and igniting increased FERC regulatory activity, very conservative management now focuses on paying down debt, cutting the operating costs and raising company dividends. 

Additionally, several other factors are favoring long-term investment in these essential service companies including a more favorable regulatory environment, lower financing costs for capital expenditures, lower fuel costs and an expected favorable funding bill to offset the cost of the CO2 reducing technologies under an Obama administration and Democratic legislature. This is the opposite of the punitive taxation policy that has been debated over the past two yeras by the Congress. This means the risks of a "rate shock" based upon coal emissions is greatly reduced and allows for higher earnings in "favorable" states where the cost CO2 reduction may be subsidized or rate based.  

In light of the relative safety of their dividends and given their recession resistant essential nature, I want to take advantage of the solid managements that cut debt and leverage and the favorable regulatory environment by initiating and adding to positions in the essential services sectors. Over the next several weeks I'll be discussing the best of breed within the various sectors. I have been researching the financial and regulatory circumstances of many of these companies and have found several that may ultimately pass my criteria test. 

Overall, these essential utilities and services are considered as "safe havens" due to their very conservative managements and continuing revenue streams. However, in this emotionally driven stock market down days can overwhelm all equities. By identifying the strongest positions within each service sector we can set low bids to take advantage of the volatility as our Disciplines require us to do. I would anticipate over the next few months to be able to acquire the best of breed in each sector at lower prices than we see today as their prices have appeared to stabilize at current levels, at least momentarily.
   
As always, I apprecaite your comments, questions and observations as we move forward to develop this thesis as outlined in the Investing For Retirement section of the web site.
 
Smooth sailing to all.

Yacht