At its core, the stock market is about people. The numbers offer clues to the odds of company’s success. But as an analyst for nearly 30 years, I’ve found keeping tapped in to the market mood is no less essential.
Equally, when you’re running a business, it’s critical to always listen to your customers. Both are important reasons why my partner at Capitalist Times Elliott Gue and I frequently get out on the road to meet our readers at investment conferences around the country, as well as Canada where we’ll be October 24-26.
This week, the two of us presented at a series of investment focused events and conferences in the Sunshine State of Florida. Thanks to everyone we talked to on our travels. This article highlights some of the answers to frequently asked questions from the people we met.
Q. Why buy stocks that have been flat to down trending over the past 12 to 18 months? Isn’t the market telling us that there are serious problems?
A. We’re four and a half years into a bull market. The stocks that haven’t stumbled at least once along the way are trading at valuations that have baked in some very high expectations.
The higher investors’ expectations are, the more difficult it is for companies to meet them, let alone exceed them. And the only way a stock’s price will go higher is if the underlying company or sector beats what the market expects of it.
The stocks that have lagged the market over the past 12 to 18 months have done so for a reason. Mainly, there’s a risk that is widely known and has caused it to underperform.
What we’re essentially doing by buying the laggards is betting they’ll overcome the challenge(s) that’s caused investors to look elsewhere. If they can, we can look forward to powerful capital gains in addition to the offered dividend yield.
In contrast, outperformers of recent months face a much tougher hurdle. And if they disappoint, they’re more vulnerable than ever to a steep correction, even if the end of this already long in the tooth bull market is still several years away.
Q. Given the recent near-death experience in Washington with the budget battle, shouldn’t we be gearing up to protect ourselves from a similar fiasco next year, when the new deal expires?
A. As I wrote last week, the odds of a true US government default were always low (also see Elliott’s article on the subject here).And in retrospect, it’s very clear to me that this push to the edge was always about raising money from each party’s extreme partisans to fund 2014 and 2016 elections, rather than a true “line in the sand” on policy.
We can debate all day about whether the Republicans’ move to push the envelope on the federal budget was worth it or not. But for the economy, I think the end result is slower growth than we would have seen otherwise. And that almost certainly means a bigger balance sheet for the Federal Reserve as it continues to push an unprecedented easy money policy.
The stock market of course loves easy money. And so long as the Fed is pursuing the Quantitative Easing 3 policy—very likely continuing under new Chairman Janet Yellin—it will be a plus for the market.
As for the Federal budget, debt-to-GDP is already at its lowest level since the 2008 crash. That’s because of the compromises made during the budget battle of 2011.
And the current deal on the budget looks like it’s going to include deficit-closing measures as well. That’s basically what S&P has been implying by boosting the outlook for the US government credit outlook recently. And it’s very likely why we’re seeing such strong support for US Treasury debt in the wake of this agreement.
As I’ve been on the road during the current budget battle, I’ve had an opportunity to watch a lot more investment TV than I usually do. My conclusion not surprisingly is TV’s sole purpose is to get eyeballs. But anyone trying to get a real perspective on issues like this is much better off just watching the market and pushing the mute button.
Q. What’s your view on healthcare stocks now that Obamacare is the law of the land?
A.My partner Elliott Gue has what I think is a real break through article in this issue of Capitalist Times on Aetna.
Mainly, this company has known what was coming with Obamacare and has adapted. It’s therefore a cheap stock with low debt and a very secure franchise—a buy by any definition.
I’ve also recently recommended GlaxoSmithKline (NYSE: GSK) to Capitalist Times readers for the LifeLong Income Portfolio. Big Pharma has always been a great sector for income investors because of its extremely reliable revenue and the graying of America.
The era of blockbuster drugs, however, has passed, and the real money in pharma is in niche drugs that can be developed, produced and distributed cost effectively.
Glaxo has made this tack in what’s otherwise become an increasingly competitive industry compromised by tightened regulation. It’s a buy for income investors in a sector that for the most part is too risky for anyone concerned with safety.
Q. Will there be a new tax on MLPs? Should we expect a repeat of Canada’s Halloween Massacre in 2006?
There’s absolutely nothing to indicate an impending tax on MLPs similar to Canada’s tax on trusts. One reason is simply that MLPs are still a relative fly speck in the US market.
The entire market capitalization of the Alerian MLP Index, for example, is only a little more than half the market cap of ExxonMobil (NYSE: XOM). And taxing MLPs would yield less than $1 billion to the US Treasury in corporate levies, though it would arguably shut down development of pipelines in the US and thereby crash the energy industry.
The most important lesson of the Canadian tax on trusts is that companies with good business plans—including every company in the pipeline industry—did not cut dividends despite the tax on trusts. Most converted to corporations and then resumed raising dividends again.
Their stock prices fell initially when the trust tax was announced. But by the time the actual tax kicked in in January 2011, most were on much higher ground, and they haven’t looked back since.
So long as you own well-run MLPs and are patient, you’ll come out in good shape even if there if there is a new tax on MLPs.
Again, we think the odds of a tax on MLPs are quite remote. But so long as you pick good individual MLPs, the lesson from Canada is you’ll come out whole, no matter what happens in what’s become an inherently unpredictable US Congress.
Q. Some of your worse performers of the past couple years have been on fire recently. What’s the deal with Atlantic Power (NYSE: AT) and Linn Energy (NSDQ: LINE)?
We’re still waiting on earnings from both companies. And I would hesitate to offer too many conclusions about what we’re going to see.
But it’s clear to me that the short sellers are getting very nervous about what we’re likely to see: Mainly that these companies aren’t sliding into oblivion, that dividends are likely to hold at current levels and that beating what are now extremely abysmal expectations is going to be relatively easy for both companies.
There’s been no real news on either company since the last time we wrote about them. Linn’s deal to buy Berry Oil (NYSE: BRY) still hasn’t closed. The Securities and Exchange Commission isn’t likely to close out their still “informal” investigation any time soon.
Atlantic is still wrestling with low wholesale power prices, which are inhibiting its ability to roll over contracts.
On the other hand, both of these companies are pricing in what’s clearly very negative expectations for distributable cash flow and distribution sustainability. It’s not going to take much to beat those projections.
That’s enough to keep holding onto both, though not enough to add to positions. We’ll be reporting on the numbers in coming weeks.
Q. Will the Keystone XL pipeline ever be approved?
A. A better question would actually be why virtually every other pipeline in the US has been approved while this one has not.
And the answer is that this one has become a cause celebre for major campaign contributors. The game in politics for off-election years like 2013 is always about raising money. And by blocking or at least delaying Keystone XL, Democrats have been able to keep a key fund raising constituency happy.
Bringing oil from the tar sands to Gulf Coast refineries would, or course, emit far less CO2 than shipping heavy oil to the US from other lands already does.
Building Keystone XL’s Northern leg—the so-called Southern Leg will start pumping oil later this month—would go a long way to reduce the current congestion in North America’s pipeline network, narrowing the massive price differentials that are now threatening the health of many Canadian and US producers.
Finally, there’s no indication the vociferous opposition to Keystone XL or the Obama Administration’s denial of approval so far are doing anything to slow the development of Canada’s tar sands.
The capital behind the biggest projects is extremely patient, and is fully prepared to continue development in the knowledge that tar sands output will eventually either go out through the US or Canada’s east and west coast, and probably all three.
If I had to guess, I would say Keystone XL will continue to be delayed, rather than outright rejected. It’s also possible TransCanada Corp TSX: TRP, NYSE: TRP) will elect to walk away from the project entirely, despite having spent some $1.5 billion already, and wait for a more accommodative administration.
Even TransCanada, however, has a wealth of other capital spending projects to pick up the slack and continue to fund regular dividend increases. And again, virtually every other pipeline or energy midstream project is winning swift approval from US regulators.
In fact, the only pipelines being canceled are by developers themselves, who have been unable to secure sufficient long-term contracts beforehand.
Q. Shouldn’t we sell our MLPs and utilities now that interest rates are going to go up?
A. The conventional wisdom trumpeted in the investment media is that stocks paying dividends are essentially bond proxies.
So the theory goes, when the Federal Reserve inevitably starts “tapering” off its Quantitative Easing 3 policy, interest rates will soar in the US and dividend paying stocks will follow bonds lower.
Worries that so-called tapering is at hand have weakened dividend-paying stocks since late April.
Ironically, a simple correlation analysis demonstrates clearly that dividend paying stocks follow the overall stock market, and are frequently in opposition to the bond market.
In fact, they’ve staged their best rallies over the past five years when interest rates have risen, and their worst declines when rates have fallen.
Remember the second half of 2008? The benchmark 10-year Treasury note yield fell sharply—the mother of all bond market rallies.
The stock market on the other hand had its most sudden decline since 1929, and dividend paying stocks went right down with it. Conversely, following the market bottom of March 2009, dividend paying stocks soared even as benchmark interest rates rose.
Like other stocks, dividend payers responded positively to sign the economy was gaining strength. Interest rates, essentially the cost of money, rose on that news as well.
Rising interest rates can hurt dividend paying stocks in capital intensive industries by making it more expensive to borrow. Borrowing rates, however, have been at historic lows now for four years and companies have taken full advantage to extend maturities and cut interest costs.
That means rates are going to have to rise a great deal and for an extended period of time to have a real impact on companies’ earnings, which drive dividend paying stocks’ returns just as they do other stocks.
Moreover, the only way a real rise in the cost of money is possible is if there’s sufficient demand. And that’s only possible if economic growth really picks up. A boost in economic growth means fatter sales, which if history is any guide will more than offset the impact of rising interest rates.
I believe there are two lessons here:
Beware conventional wisdom. It’s often based on false premises and this is a prime example.
Grandiose investing theories only matter to the extent they affect results on the ground.
Some companies have suffered from rising borrowing costs even with benchmark rates low, because they’ve suffered from a lackluster economy. But you wouldn’t know that unless you were watching their business results, rather than just making assumptions based on the macroeconomic theory du jour.
If you’re going to buy stocks, you have to pay attention to how the business is faring. Rising interest rates spurred by faster economic growth may hurt some companies.
Others, however, will thrive. Success and failure will be in each company’s numbers, not the latest pronouncements of TV analysts who only operate above the clouds.
Q. What’s your view on AMLP?
A. I think it’s a trading vehicle for MLPs as a sector. And shorting it is possibly a good way to hedge a portfolio that’s heavy in MLPs. But it’s a remarkably poor substitute for owning a well-chosen portfolio of first-rate individual MLPs.
Mainly, we’re now 4.5 years into a bull market for MLPs. The key catalysts for more upside in the energy midstream MLPs that make up the Alerian Index—what AMLP represents—are strong as ever.
The most important is the great North American Energy Boom from unconventional resources—shale, tar sands, etc—and the need to fuel it with infrastructure.
In my opinion, we’ll know we’ve reached a top in this market when pipeline companies start to build projects without signing on customers to long-term contracts in advance.
That’s definitely not happening now.
In fact, we’ve seen several high profile projects canceled because they failed to get enough support in advance.
On the other hand, many MLPs that used to yield upwards of 6 percent are now yielding barely 3 percent. They’re pricing in all that good news and a lot more. The burden of expectations is so high that it’s hard to see what’s going to push them higher.
Conversely, other MLPs such as LifeLong Income Portfolio member Kinder Morgan Energy Partners (NYSE: KMP) have been pushed off their highs and now trade at huge discounts to their peers. Kinder, for example, now yields more than two percentage points above Enterprise Products Partners (NYSE: EPD), despite faster distribution growth.
In Kinder’s case, it’s largely because of what amounts to a “Bear Raid,” spurred by an extremely negative opinion released into the blogosphere from publishing company Hedgeye Risk Management.
Hedgeye’s key argument is Kinder’s incentive distribution rights (IDRs) structure is so egregious in kicking back profit to general partner Kinder Morgan Inc (NYSE: KMI)—more than one-third owned by founder Richard Kinder—that it’s not adequately investing in its core business.
In recent weeks, we’ve refuted these arguments for readers of our Capitalist Times, Conrad’s Utility Investor and Energy and Income Advisor, including through an exhaustive industry-wide study of IDR (Incentive Distribution Rights) structures by Elliott Gue.
Kinder’s own very strong third quarter results and 2.3 percent distribution increase (a 9.2 percent annualized rate) are even more compelling proof. And the upshot is Kinder is a very strong buy at current prices, even as much of the MLP industry is quite pricey.
The point here is that if you view all MLPs as identical and moving in lockstep, you’re going to miss out on some compelling investment opportunities.
And you’re going to be stuck in MLPs that have risen so far so fast that the best we can hope for is flat performance until business growth catches up. Buying AMLP as an alternative to picking out the best MLPs is, in other words, a formula for mediocre returns.
Q. Won’t rail transportation eliminate the need for new pipeline construction in North America?
A. Not unless they figure out a way for railroads to run without burning energy. Rail is beating pipelines in some of the more remote areas where energy drilling is going on, simply because there are no pipelines. But where there’s pipe and rail, the shipper is always going to choose to contract the former.
The other problem with energy by rail is safety. An oil-laden train that ran off the rails earlier this year basically destroyed a town in Quebec with many deaths. That’s a different level of devastation than pipeline leaks, which admittedly occur all too frequently.
Pipeline companies are not building unless they can guarantee the revenue when they finish projects. That means capacity is going to continue to lag demand from producers. And that means producers are going to have to continue to ship by rail for years to come. You’d be hard pressed, however, to find a railroad with a stock price that doesn’t already reflect that.
There are some bargains among companies that are cashing in on rail, such as Parkland Fuel Corp (TSX: PKI, OTC: PKIUF). They run a logistics business that’s complimentary to their fuel distribution operations across Canada. Pembina Pipeline Corp (TSX: PPL, NYSE: PBA) has several projects linking its midstream assets in processing, storage and shipping to rail.
For the most part, however, this is a theme with some pretty lofty expectations baked in. There’s more value in pipelines, which are a far cheaper alternative for transporting energy when they’re available.
Q. What’s the deal on taxation of foreign stocks?
A. Outside of Singapore and Hong Kong—and with the exception of Canada for US IRAs—virtually all countries withhold a portion of dividends paid to foreigners by companies headquartered within their borders.
Assuming you have income to write it off against, you can claim withholding tax as a credit by filing a Form 1116 with your US taxes. Higher bracket investors usually get everything back. Lower bracket investors may have to roll over at least part of the credit into future years to use it fully.
I recommend a large number of Canadian stocks. The tax is 15 percent on dividends paid to non-IRA accounts, and 0 percent on dividends paid to IRAs.
Australia’s rate is 15 percent on both, which conveys an advantage to holding outside of IRAs. But keep in mind IRAs will shelter capital gains and dividends paid into them.
Probably the highest withholding tax on companies I recommend is in France and Italy, which are in the 20 to 25 percent range. I think the merits of the companies I like—Total SA (France: FP, NYSE: TOT), for example—outweigh the inconvenience of the tax. But those most concerned about recovery may want to hold them outside of IRAs, so they can claim the full credit on the Form 1116.
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