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Investment Strategy

Unconventional Investing for the Win

By Roger S. Conrad on Oct. 14, 2014

Conventional wisdom holds that October is a dangerous month for stocks, which means that investors must think unconventionally to get ahead.

Consider that the Dow Jones Utilities Average has generated a positive total return in 31 of the past 45 Octobers. And despite the recent downdraft in the broader market, this index has rallied 2 percent thus far in October.

Investors should also note that since 1969, the Dow Jones Utilities Average has tumbled in the final two months of the year only four times after posting a loss in October.

Three of these instances—1973, 1987 and 2008—were full-blown market crashes. The other year-end downdraft occurred in 1993, when California ignited a firestorm by proposing radical changes to the electricity market.

In other words, utility stocks usually rally in October and enjoy a strong fourth quarter.

Although the scare-mongering financial media takes every opportunity to stoke fears about global deflation, the spread of Ebola and slowing economic growth in Asia and Europe, October 2014 shares little in common with fall 2008

Despite an explosive five-year bull market and plodding US economic recovery, corporations and governments alike continue to de-risk operations and balance sheets.

The happy result: Even many junk-rated corporations have the flexibility to pull bond offerings when credit conditions tighten.

Last week, B1-rated master limited partnership BreitBurn Energy Partners LP (NSDQ: BBEP) cancelled a $400 million bond offering, for which it would have paid 8.5 percent interest.

The first third of October has brought its fair share of turbulence to the broader market, with the energy sector bearing the brunt of the pain. This downdraft has hit the Alerian MLP Index, which has given up more than 8 percent of its value this month.

More downside could be in the offing; the market has been overdue for a breather. Investors should regard further weakness as an opportunity to buy high-quality names, many of which had traded at stratospheric until recently.

The October issue of Conrad’s Utility Investor highlighted four unconventional investment opportunities and the best stocks to take advantage.

Opportunity No. 1: International Intrigue

The strengthening US dollar has punished stocks priced in foreign currencies for the past 12 months.

On the plus side, formerly expensive stocks in Canada, Australia and elsewhere have pulled back to favorable price points for patient investors.

Opportunity No. 2: Irrational Fear of Rising Interest Rates

Despite what you may have heard, rising interest rates don’t necessarily spell doom for utilities and other dividend-paying stocks.

First and foremost, these equities offer the potential for dividend growth; rising interest rates are more of a headwind for bonds, a security class that pays a fixed coupon.

More important, stocks have scored big gains in years when interest rates have climbed significantly (2009 and 2013) and underperformed when rates have tumbled (2008).

(Click graph to enlarge.)
Dvd Stocks vs Interest Rates

Nevertheless, plenty of investors view these stocks as bond proxies and have bet against them. Short interest in some of the highest-yield names in my Utility Report Card, which covers more than 200 essential-services stocks, has reached levels that could set the stage for en epic squeeze.

Earlier this year, we booked profits of more than 50 percent on regional telecoms Windstream Holdings (NSDQ: WIN) and Consolidated Communications (NSDQ: CNSL), both of which surged after improving results and unexpected moves to unlock value squeezed the shorts. (See An Early Birthday Present from Windstream Holdings and Book a 54% Gain on Consolidated Communications.)

Opportunity No. 3: Indiscriminate Selling in the Energy Sector

The price of Brent crude oil has tumbled since late June, catalyzing an indiscriminate selloff in the energy sector. Even midstream companies without direct exposure to commodity prices have taken a hit.

With Saudi Arabia keen to preserve market share in the US, West Texas Intermediate crude oil could slide into the $70s per barrel before finding a bottom. On the supply side, the expense involved in incremental production growth should ensure that today’s low prices don’t last over the long haul.

The selloff in many of our favorite midstream master limited partnerships (MLP) appears overdone; this pullback represents the opportunity we’ve been waiting for.

Opportunity No. 4: Politics as Usual

The financial media always focuses on the big-ticket races in each election cycle; this time around, control of the US Senate is at stake.

Although we monitor political developments and their investment implications closely, the real victor at the national level will be more gridlock.

For utility stocks, results of key gubernatorial elections will hold more sway over utilities’ prospects, as the victors will appoint regulators. In some instances, these changes could be sanguine for relations between utilities and regulators; in other cases, these interactions could become far more hostile.

Utilities Navigate Energy Politics highlights what’s at stake in several key gubernatorial elections, while the November issue of Conrad’s Utility Investor will analyze election results. Based on the winners and losers in the political arena, I’ll highlight my picks and pans in the utility sector.

If you haven’t already subscribed to Conrad’s Utility Investor, learn more about the publication’s valuable features and how you can save $50 on a risk-free trial.

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Risk and Reward

The longer the current correction lasts, the better the buying opportunity for savvy investors. My buy targets in Conrad’s Utility Investor reflect a common-sense balance of risk and reward, informed by almost 30 years of covering utilities and other essential-services firms.

My shorthand measure for prospective returns: current yield plus dividend growth, as prices of dividend-paying stocks tend to follow their payouts over time.

The Utility Report Card also features my easy-to-understand Quality Grades (A for the best, F for the worst) that rank the more than 200 essential-services stocks that I cover by risk.

Here are the main criteria that I factor in to this proprietary metric:

  • Dividend Coverage: The Utility Report Card includes the payout ratio that’s based on the most relevant measure of cash flow—not necessarily what the companies report in their press releases. Unlike other services, Conrad’s Utility Investor doesn’t employ a one-size-fits-all methodology because this measure can differ between industries and companies
  • Revenue Sustainability: Many investors were surprised when Boardwalk Pipeline Partners LP (NYSE: BWP) slashed its distribution earlier this year because the MLP’s low payout ratio obscured the risk associated with expiring long-term contracts. In contrast, Buckeye Partners LP (NYSE: BPL) has managed to maintain and grow its distribution, despite cash flow shortfalls. The secret: a visible pipeline of growth projects that are backed by contracts with customers.
  • Regulatory Risk: In my almost 30 years of analyzing utilities and other essential- services companies, regulatory relations can affect a firm’s prospects dramatically. Regulators set the allowed rate of return on system investments and may institute mandates related to renewable energy.
  • Near-Term Refinancing Risk: We closely monitor forthcoming debt maturities to gauge a company’s flexibility to cope with business-related challenges or tightening credit conditions.
  • Operational Efficiency: Limiting unnecessary costs and system downtime determines how close a utility will come to earning the returns allowed by regulators. The opportunity to improve Pepco Holdings’ (NYSE: POM) abysmal return on equity of 7.1 percent, for example, is a major incentive for Exelon Corp’s (NYSE: EXC) pending acquisition of that company. (Check out my free video analyzing this deal.)
  • Dividend Growth: Far too many investors consider a company’s past track record of dividend growth and fail to anticipate future changes to the upside or downside. Earlier this summer, the market piled into dividend-paying stocks with well-understood growth stories, bidding these names up to frothy valuations. Many of these names have pulled back sharply in the recent correction. A dividend hike sometimes provides a false signal regarding a company’s underlying strength; however, in conjunction with other metrics, a payout increase is one of the best indications that a utility is in good health.

In a bull market, the good, the bad and the ugly all rise. But investors build sustainable wealth by buying high-quality stocks when the broader market sells off or these names suffer a temporary hiccup.

A rational analysis of risk using the above criteria—coupled with a conservative look at prospective returns—is the best way to identify good buys that will stand the test of time.

There are no worthwhile shortcuts in security analysis. But my studied approach to investing has uncovered new opportunities where less experienced investors see none.

Sign up for a risk-free trial of Conrad’s Utility Investor to see what a difference diligence and experience can make to total returns. You won’t be disappointed.

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ABOUT ROGER CONRAD

Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b