Free Tips to Protect Your Portfolio

Last week, I accompanied a handful of adult leaders and three-dozen boys of varying ages to scout camp in the Virginia mountains. The first day’s weather was unexpectedly cool and rainy. As the week progressed, however, the days were increasingly hot and dusty. Not surprising, tempers rose accordingly, calming only with the oncoming chill of night and the eternal fascination of a raging campfire.

As it turned out, my experience at camp is pretty much a perfect metaphor for the volatile, emotional action last week in the stock market. As is always the case, those who allowed themselves to be swept up in hotheaded fear have been burned. Those who found a way to keep cool are basically where they began the week and still very much in the game.

History has shown us again and again that the key to surviving bear markets is to focus on quality. In other words, as long as an underlying company is strong, its stock will ultimately recover whatever pounding overwrought investors deliver in the near term.

Conversely, if the underlying company is rotten, there’s little hope of recovery. That’s why it’s so important to keep tabs on how your companies are faring as they face the challenges of rising raw material costs, a slumping US economy and tight credit conditions. And it’s why a hard-headed, unemotional analysis of second quarter 2008 earnings results will be so critical in the coming days.

Rest assured, if any of the companies represented in my advisories truly weaken—be they Canadian Edge, Utility Forecaster, Vital Resource investor or Personal finance Income portfolio recommendations—I’ll sell. That goes for bonds and preferred shares as well as common stocks.

On the other hand, if companies show the kind of strength I expect, I’ll be holding on, no matter how wild and wooly the market action gets, because a strong business always recaptures lost value in the market place once investor emotions cool. And keep in mind that with most of my recommendations we’re being paid to wait, sometimes with dividends well in the double digits.

Behind the Selling

The equally important corollary to the rule of quality is a stock can really only be taken down for the count if the underlying company is truly rotten. We’ve certainly seen that happen to a large number of companies in recent months, from ill-conceived income deposit securities such as sports facility concessionaire Centerplate to highly leveraged mortgage issuers.

The jagged decline and subsequent bounce in shares of Fannie Mae and Freddie Mac last week are dramatic illustrations of just how dire things have gotten in the home lending market. Federal government statements of support for both mortgage lenders of last resort may mark the bottom for both. But there are almost surely further heavy writedowns coming from this industry, with the second quarter likely to see acceleration from the first.

Not every bank, however, is rotten to the core and headed for seizure. The seeds of destruction are always sown with boom-time greed. In the case of the 2000-02 technology crash, it was the stock options of the 1990s. For cascading utilities and telecoms early this decade, it was the extreme leverage and overbuilding during deregulation in the prior decade.

In the case of financials, trouble always begins when management abandons caution in order to maximize lending and, therefore, earnings. Unlike prior cycles, this one has hit harder because it’s tied in with a multiyear boom in housing that outlasted bankers’ caution and a simultaneous squeeze on consumers from surging energy prices.

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Individual banks are far from equally exposed to the turmoil, however. The most aggressive in the prior cycle have already failed, and they could be joined by others in coming months, with the ranks of regional banks looking the most vulnerable.

Sooner or later, however, some banks will prove to the market they’re up to the challenge of survival. When that happens, this sector will be off to the races. Earnings may continue to lag for several more quarters, and the US economy may continue to slide. But at that point, all the bad news and more will be priced in, and all but the strongest hands holding these stocks will be shaken out. That’s the stuff that ends the selling season, and it will this time around, just as it has every other time.

Second quarter results from mega-bank Wells Fargo announced last week were one of the most encouraging signs for the banks in a while. The fifth-largest US bank posted a 16 percent increase in revenue en route to earnings per share of 53 cents that handily topped Street estimates.

Heavily owned by value-maven Warren Buffett, Wells has long been known as the savviest of the mega banks. Its results aren’t likely to be matched by any of its competitors—and, in fact, weren’t last week by JP Morgan. But they’re a pretty clear indication that at least some banks are still on very solid ground, despite the sector turmoil. And that’s a good sign that recovery isn’t too far off.

Recessions or economic slowdowns by definition impact earnings negatively. That’s why my chief criterion for sticking with any stock in this bear market isn’t necessarily keeping earnings growth at a high level. Rather, it’s whether or not the company is navigating its way through these harder times on the way to becoming a more valuable investment.

Admittedly, that’s a lower bar than during boom times. But it’s especially appropriate for high-yielding companies; you really don’t want to sell unless the dividend is truly at risk. The key is, as long as the payout keeps flowing, the pummeled stock will always recover, regardless of how crazy the market action gets.

Of course, it’s precisely the safety of the dividend that’s on investors’ minds when a high-yielding stock falls. As I’ve pointed out in previous issues of Utility & Income, when a stock drops precipitously, many investors assume that there’s something going on they don’t know. The result is they sell, driving the stock down further and thereby creating more fear and panic, which creates more selling.

As long as the underlying company is solid, this cycle will eventually break. Management will eventually post numbers or take some action that completely blows the rumors out of the water. The buyers then swamp the sellers, and the share price rallies.

Don’t Fear the Shorts

Action is particularly sharp when there are short sellers in the game. Short sellers, of course, lose when the price of a stock they’re shorting rises. What many don’t realize is they generally lose at least twice as fast as buyers gain because most employ at least 50 percent margin for their trades.

Put another way, most buyers of stock pay the full amount for whatever shares they purchase. Some will borrow, or “margin,” up to 50 percent of the value they buy, but they’re generally a small number of the total owners of the stock.

In contrast, a hefty portion of the profit from shorting comes precisely from the use of margin. When you short, you typically have to put up half the market value you’re shorting as collateral. Consequently, your gains are double the down move in the shorted stock. Conversely, your losses are also at least twice the gain in a stock.

One theory making the rounds the last several months has been that short sellers have “targeted” certain companies for a takedown. The story goes that short sellers drive down share prices by entering positions, which, in turn, drives up the fear level and induces those holding the targeted stock to sell. The company’s market value therefore drops, which triggers debt covenants and threatens its solvency, forcing drastic action by the company to avoid bankruptcy that often guts shareholder value further.

There are certainly instances of this happening. Important, however, it’s only possible with companies that are in need of major outside financing to keep operating. Companies that don’t depend on constant access to capital can certainly take a hit, and we’ve seen many do so over the past year. But fundamentally, if they’re able to get by on their own resources, they can wait out the selling, no matter how severe it gets. Eventually, they’ll prove to the market that they’re solid, and shares will rebound.

Those who sold short too aggressively will be forced to liquidate positions quickly or risk being wiped out. Failure to do so in a timely way is why most people lose money when they short stocks and why litigation-wary brokerages generally restrict who they allow to sell short.

Over the past several years, I’ve written quite a bit about Atlantic Power Corp in my various advisories. Until recently, my comments have basically been about its value as a conservative, cash-generating and wealth-building investment.

The company pays a double-digit yield backed by solid portfolio of investments in power generation and power line assets in the US. Management doesn’t operate anything. Rather, it manages the cash flow from its investments by controlling risk to it.

For example, currency exposure—Atlantic’s dividend is paid in Canadian dollars, and its revenue is in US dollars—is handled by multiyear hedge positions altered only when asset purchases are made. Fuel costs are typically passed through to customers, all of which are investment-grade credits and most of which are regulated utilities. The vast majority of debt is at the project level and is timed to be paid off when current power sales contracts end.

First quarter results confirmed the continuing success of this strategy, despite the slowing US economy and higher fuel costs. And management has affirmed the same for the second quarter.

Nonetheless, for the past two weeks, the shares have come under enormous selling pressure. Until Friday, the only news from the company was to reaffirm the safety of its dividend and a statement that there was no fundamental based reason for the volatility in its share price. The only news from the analyst community was two upgrades from hold to buy.

Many investors, however, apparently made the determination that there was something wrong they didn’t know about. Some bought into the wrongheaded notion that there was some way short selling alone could destroy the company.

Of course, anyone who has done a lick of research on Atlantic can clearly determine the company hasn’t depended on outside capital for some time, other than to make asset purchases. The company’s total number of income participating securities (IPS) outstanding is basically unchanged over the past year.

The drop in the share price was painful and scary, and at least for the moment, it’s made it more difficult for Atlantic to issue new IPSes, which combine equity with a bond portion worth approximately USD6 a share. But unlike the Thornburg Mortgages of the world, Atlantic doesn’t depend on new capital except to make new acquisitions, which is entirely at management’s discretion. So is the redemption of the bond portion of the IPS, which could occur as early as November 2009 or as late as November 2016. Again, management has covered this potential risk well.

The bottom line is there’s no way for a lower share price alone to threaten Atlantic’s survival. And unless the likes of giant utility Southern Company go bankrupt, its internal cash flows are rock solid as well.

All this, of course, came into graphic relief Friday. That’s when management announced a plan to buy back and cancel up to 8 percent of its outstanding IPSes. Quoting Barry Welch, president and CEO:

“Recent activity in the trading of our IPSs has resulted in a current market price that is significantly lower than the value of the Company. Our assets are operating as expected and there have been no changes in our underlying business that justify the recent decline in the market price of our IPSes. In addition, the Company has a very strong current cash position that is adequate to support this issuer bid and our stated strategy of growing shareholder value through acquisitions. As a result, the purchase of our IPS for cancellation under this issuer bid represents an attractive investment opportunity, and an appropriate use of the Company's available cash."

The underlying business strength to do a buyback has, of course, been demonstrated in earnings quarter after quarter since the company’s inception in late 2004. And this announcement makes it pretty certain that we’ll see it again in the second quarter numbers, due out Aug. 13.

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Sometimes, however, it takes such a move by management to really put the kibosh on false rumors. And perhaps more important, this move increases the future value of Atlantic because it will retire IPSes early at a low price, slashing debt interest and reducing the cost of retiring the bond portion of the IPSes, which management has hinted at as early as November 2009.

Not surprising, Atlantic’s shares surged 20 percent-plus Friday. That wiped out the losses and then some in what had been a particularly trying week for shareholders. Conversely, any short sellers suffered losses of more than 40 percent in just a few hours trading, a sobering reminder than you can lose heavily shorting even a falling stock in a bear market.

Of course, those who read between the lines a little know I’m deeply skeptical of any market theories that blame share price drops purely on short sellers. Short selling is only profitable when something is really rotten or bid up to an unsustainable height.

Like those who buy stocks, short sellers are in it to make money. But they also provide needed liquidity to markets. They’re not inherently evil, nor do they operate as some kind of conspiracy to destroy good companies. That only happens when the company itself is skating on thin ice and is unlucky enough to fall in.

Short selling can help drive a stock lower in the near term. But short sellers can’t force anyone to bail out of a good position. And when a shorted stock pays a big dividend—as most of my recommendations do—the short sellers have to make good on the needed cash. That gets old real fast, unless something really is falling apart. And as long as the health of the companies you own is strong, that’s not a threat.

Not Gored Yet

The other major issue I want to comment on this week concerns energy. Over the past couple weeks, we’ve seen oil and natural gas prices come off sharply. That, in turn, has dragged the prices of many energy-related investments lower, from actual producers to even infrastructure-owning limited partnerships and utilities.

Important, however, both fuels are still well up for the year. Moreover, as my colleague Elliott Gue, editor of The Energy Strategist, has pointed out, the dramatic selling has come despite continued tight inventory conditions and threats to global supplies, both from resource nationalism and some emerging and very real limits on what can be produced.

Rather, it’s almost entirely grounded in fear that a US recession will worsen and go global, triggering a collapse in demand worldwide. In other words, the troubles at Fannie Mae and Freddie Mac were arguably much more important for investors last week than actual energy market conditions, which remain quite bullish.

Admittedly, the news from the US market isn’t great. But there are three things to keep in mind here. First, no energy stocks are trading on the basis of $130 oil or even $100 oil. In fact, a recent UBS report puts the baseline oil price at just $85 a barrel for Canadian income trusts such as Enerplus Resources.

Super Oils are trading at single-digit multiples to even lowest-case projections for full-year 2008 earnings. And service companies and smaller producers are arguably cheaper still.

Second, the current level of dividends is arguably set for a much lower level because first quarter realized prices for oil at the trusts averaged less than $80 a barrel and gas averaged less than $8 per million British thermal units. We’d have to see at least several months of $70 oil and $6 gas for any trust distributions to come under attack again and even further declines for the likes of Enerplus to be at risk.

Finally, as the ’70s showed, energy prices are extremely volatile even in bull markets. And after a parabolic run to $140-plus this year by oil, black gold and its sister fuels coal and natural gas were due for a break.

Recession alone, however, has never been enough to break the back of an energy bull market. That’s only achieved by truly long-term efforts to conserve, move to alternative fuels and ferret out new discoveries of conventional reserves.

We’ve seen some movement in this direction over the past several years. Wind power plants, in particular, have proliferated. There’s some evidence at least US oil demand is well below last year’s levels, as consumers have curtailed their driving habits. And Congress has agreed to open up previously off-limits coastal areas to oil and gas drilling.

Unfortunately, we’re still a very long way from the magnitude of the behavior changes of the ’70s and early ’80s, which eventually ended that energy bull market. In fact, any drop in prices now is likely to discourage further conservative, alternatives and new energy development. And that guarantees this bull market will eventually resume and go on to higher highs.

Before this sell-off began, I encouraged readers of my various advisories to take some of their profit from energy positions. As it turned out, that was a good time to do so, but that time has now passed.

Now is a good time to accumulate positions in good income trusts, Super Oils and other companies involved in the industry. Pipeline limited partnerships also look cheap, and even many utilities—which are basically recession proof after five years of radical reduction in debt and operating risk—have ratcheted back to better prices.

To be sure, prices could come down further still in the coming weeks. Investors are going to remain focused on the potential for a really bad global recession for some time. And that’s only likely to change when financial companies have really hit bottom, which could be weeks or months away.

But again, the highest percentage way to make money in the market is to buy good companies when they trade at good values and ignore the volatility unless there’s a real fundamentals-based reason to worry. That’s what I intend to keep doing in what could be scary weeks ahead, and good energy stocks remain a cornerstone of my strategy.

Speaking Engagements

“The coldest winter I ever spent was a summer in San Francisco,” a saying that’s almost a San Francisco cliche, turns out to be an invention of unknown origin, the coolest thing Mark Twain never said.

The natural setting is, however, among the most exciting in the US. Venture west for the San Francisco Money Show Aug. 7-10, 2008, and conduct your own field study.

Neil George, Elliott Gue and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011362 to attend as our guest.

I also have a special invitation for readers to join me and my colleagues Elliott Gue, Gregg Early and Neil George aboard an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal.

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 800-832-2330.