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1. MARKET STATUS

Before ever considering investing in stocks, we must always first look at the overall market, since almost all stocks follow the major indices.

A. The Short Version

Still trending down, invest only funds not needed for the near term expenses. While there may be rallies, even multi-week or month ones, the fundamental problems remain and there is no credible plan to fix them at this time.

B. The Detailed Version

In purely technical terms, there’s a decelerating downtrend that may or may not signal a bottoming. The S&P, the best overall index, is making higher lows, but has repeatedly failed to crack a still declining 50-day moving average. On February 10 it again failed, this time decisively so, leading many to anticipate continued decline.

If the market were a mental patient, the diagnosis would be depression combined with bipolar disorder, causing brief but intense periods of euphoria based on irrational hope of a magic, relatively painless solution suddenly appearing.

While volumes are written daily explaining the market, the current collapse the basic story remains the same. Stocks remain in a vicious downward cycle that works like this:

1. fear from the ongoing and clearly unsolved housing/credit crisis, which causes

2. declining consumer and business spending, which causes

3. declining earnings, which causes

4. rising unemployment,

5. which causes more fear and reduced spending, etc.

In sum, a failure of leadership causing an ongoing crisis in confidence that an effective solution is coming that will stimulate real sustainable growth and employment. Rather, we’re getting the usual spin, short-term bandaging and glorified forms of welfare to those who will not generate new wealth.

We need tax credits to those who invest in productive assets which then stimulate permanent job creation and growth. For example, when given a choice to buy equipment or pay those same funds away in tax, most will invest in the equipment, and the cycle begins to reverse.

C. A Summary of Recent Events

If you haven’t been following the market, here’s the essence of what’s happened since the ten-year lows of late November. There’s a decelerating downtrend that may or may not signal a bottoming.

1. The Good:

China announced stimulus plan, good for commodities (copper rose 15%), nickel, a component of stainless steel, bolted upwards, oil holding steady for near term. Hope remains for an effective stimulus plan while President Obama & Co. learn their jobs and seek advice from the same crowd that got us into this mess.

Overall stocks stay in a trading range, some leading indicators looking better (bond yields rising, commercial paper market improving, commodities stabilizing) lends some near term optimism. Progress on the bailout package also adds optimism. Prices action shows higher lows since late January.

2. The Bad

There are plenty of clouds on the horizon. The S&P, the best overall index, is making higher lows, but has yet to crack a still declining 50-day moving average. On February 10, it failed again, this time decisively, creating a pessimistic technical picture (for those into technical analysis). All the problems I’ve mentioned recently remain. For example, something like a quarter of all mortgages may go under in the coming year and as yet no solution.

As for destabilizing attacks and threats from Islamic terror and Russian adventurism, the question is WHEN, not if, they stage another major “event” as seen in New York, London, Bombay, or Georgia (see “The Islamic-Russian Wildcard Bonus?” in my December article “Top Energy Infrastructure MLPs…” at my site). Remember US Vice President Joe Biden’s campaign trail admission that the Obama administration’s resolve would be tested?

3. The Ugly

Jobs data has been terrible, but not worse than expected. Employment, however, is also a lagging indicator, meaning that it can continue to deteriorate when a turnaround is already in progress. Nonetheless, it badly undermines confidence and consumer spending.

In sum, we appear to be in the upper part of a near term trading range. No strong evidence for more than that at this time.

D. Ramifications for High Dividend Stock Investors

In sum, we’re in a near term trading range, with the overall trend continuing down with a retest of November lows likely. Continue to invest only with funds you don’t need for the next six to eighteen months at least. What you buy now may well go lower.

However, there is a lot of cash on the sidelines now, earning virtually nothing. There are big players and insiders buying many of the stocks I’m following that are clearly cheap and excellent long term values. As the past few months have shown, any glimmer of positive news brings buyers as everyone is waiting for the sign to jump in. So upside moves can and will be sudden and strong, even if short lived.

So if you can earn reliable dividends from 8-12 plus percent and more while you wait for recovery, ongoing investment makes sense. You just need to find the best bargain priced quality high dividend securities. I particularly refer to those I’ve mentioned earlier. Since we must be very selective now I focus only on my very favorites.

E. Why Energy Is the Best Sector for Reliable High Income and Appreciation

Here’s the basic thesis for income investors overweighting energy companies.

  • Governments are doing everything they can to stimulate growth. There will be no growth without increased energy consumption.
  • As part of their various stimulation packages, governments are printing lots of money, which will ultimately drive up commodity prices, particularly for vital commodities like energy.
  • Besides macroeconomics and money supply, an additional boost will come with the Obama Administration’s focus on stimulating domestic oil and gas production, especially gas because it's cleaner.
  • Many energy company stock prices are oversold to levels not seen since $20-$30 oil.
  • For all the talk about renewable and green energy, we still have no serious replacement for oil and gas anytime in the next decade.
  • Energy supplies remains vulnerable to OPEC supply cuts, Islamic terror, and Russian aggression (see my December article “TOP ENERGY INFRASTRUCTURE MLPS…”, for more on this in the section on “The Islamic-Russian Wildcard Bonus” that benefits all energy companies at http://highdividendstocksguide.blogspot.com ).
  • There are many energy companies that pay reliable high dividends.

1. Big Integrated Energy Companies

While there are many solid businesses in this group, few pay dividends that really keep you ahead of inflation and taxes. One exception is BP plc (NYSE:BP). While it isn’t the strongest of the group, its approximately 7% dividend is safely backed by a solid financials that will improve along with energy prices within the next year or so. BP is a Buy at 46, a Strong Buy under 41.

2. Energy infrastructure MLPs

All the below offer yields currently above 8.5%, which are backed by prospering businesses with reliable cash flows. The proof of this is that despite declining energy prices that have gutted the distributions of most Canadian Energy Trusts, these have all held their distributions steady. EPD actually raised theirs recently. They are bargains because they’ve been oversold amidst the general market decline, yet their revenues are more dependable and yields far higher than the overall market.

Also, many investors have wrongly believed that revenues of these energy distribution and storage companies are directly tied to energy prices. In fact most revenues come from simple volume moved or stored. Thus shares have been unfairly dragged down both by market sentiment and declining energy prices.

  • Buckeye Partners (NYSE:BPL) Buy under 38, Strong Buy under 35
  • Enterprise Products Partners (NYSE:EPD) Buy under 23, Strong Buy under 20
  • Energy Transfer Partners (NYSE:ETP) Buy under 35, Strong Buy under 30
  • Kinder Morgan Energy Partners (NYSE:KMP) Buy under 49, Strong Buy under 45
  • ONEOK Partners (NYSE:OKS) Buy under 46, Strong Buy under 42
  • TEPPCO Partners (TPP) Buy under 25, Strong Buy under 20

In my last article, I introduced another favorite sector.

3. Canadian Energy and Income Trusts, and their American Counterparts, Stock/Bond Hybrids (EISs, IDSs, and IPSs).

CANADIAN ENERGY TRUSTS

Because their revenues, and hence distributions and stock prices, are directly tied to energy, these rise and fall with energy prices. Thus they were stars for both income and appreciation until energy prices began to drop in mid 2007. Most are down well over 30%, some over 50%, along with their distributions. They will be back with a vengeance with the inevitable energy price recovery, and that are now so low they are worth the diminished risk of further price declines. But that risk remains very possible.

Many rate are great buys at current prices, since dividend cuts appear finished or already priced in. More on these in a later article, but here are the strongest buys.

Enerplus Resources Fund (NYSE:ERF)

The oldest and most well known of the Canadian Energy Trusts, its conservative, long term-focused management has slashed its dividend over 50% over the past months in order to preserve expansion projects and cut debt to preserve future prosperity. At the current price of around $19, it is selling for a bit over 60% book value and still yields over 9%. It’s one of the very best plays on energy’s recovery while you get paid handsomely for the wait. As one of the most well known, oldest and largest Canadian Energy Trusts, this one gets the most attention from institutions and funds that want to be in this kind of stock, since its one of the few that’s liquid enough for them, so it really tends to rise fast and drop slowly once energy is back in vogue. It’s a Buy under USD $22, a Strong Buy under $18 while energy remains down.

Vermillion Energy Trust (VETMF.PK)

With gas wells in Europe, as well as in Canada and Australia, Vermillion is uniquely positioned to benefit from what will likely be Russia’s ongoing periodic gas supply blackmail games to Europe. As proof of its strong fundamentals, it's one of the few Canadian trusts that has not cut dividends, and has issued strong guidance. Traditionally one of the lowest yielding trusts due to its strong fundamentals and low risk, it's been beaten down with the rest of the market and its sector and also provides yield far larger than its risk. With an annual distribution of USD $2.28 and current price under USD $20, yield is about 11%. It’s a Buy under $22, a Strong Buy under $20.

Primary Risks to These Include:

  • Further declines in energy prices: Possible but not likely to be significant.
  • Market Risk: As with any listed security, these will drop if the market continues to decline. Quite possible in the next year or so, but could be more than countered by rising energy prices.
  • Currency Risk: With price and distribution set in Canadian dollars, the exchange rate with the US dollar effects these for good and bad. Most believe that the Canadian dollar is low compared to the dollar and has better prospects for appreciation, so this may be more of a bonus than risk
  • Liquidity for Vermillion: Vermillion is thinly traded, so it doesn’t take much buying or selling to make the price move fast. The bad news is that getting out fast can be very expensive if there are no buyers and the market maker cuts the ask price drastically to protect himself. The benefit is that you can put in a lowball order 20% below current prices and have a real chance to get it if the market gets hit with another wave of sustained selling.

AN AMERICAN VERSION: THE ENHANCE INCOME SECURITY (EIS), THE INCOME DEPOSIT SECURITY (IDS), AND THE INCOME PARTICIPATION SECURITY (IPS)

In my prior article for January 2009 (see http://highdividendstocksguide.blogspot.com, “CD-Like safety, over 12% yields?! Atlantic Power Corp, and a high dividend investor's primer to stock/bond hybrids: The IPS, IDS, AND EIS”) I gave a detailed explanation of these, and briefly introduced my latest pick from this group, current recommendation, Atlantic Power Corp. Here’s the full story.

2. ATLANTIC POWER CORP. (OTC:ATPWF)

Brief Profile

The firm (henceforth ATP) owns interests in and manages a varied portfolio of 14 independent, non-utility power generation facilities in the US, and an electric transmission line in central California. ATP sells electricity to established, investment-grade utilities under long-term power purchase agreements (PPAs). It’s one of the biggest, most diverse power income funds, and its equity partners in each of the projects are experienced in operating and maintaining the facilities.

Instead of common shares of stock, ATP issues Income Participation Securities (IPSs), which are simply a hybrid security made up of a share of common stock and a subordinated bond. The stock portion of the distribution is US $0.0383; the bond portion is $0.0529, totaling $0.0912 per month, or $1.0944 per IPS annually.

A. WHY

In short, what appears to be one of the best risk/reward combinations anywhere.

1. Very High Distribution

The price of the IPSs has followed the market, and thus is down over 30% from the mid-2007 from over US$10 to around $US 6.65. At this price the total monthly distribution of $US 0.0912, $1.0944 annual, is over 16%. Yields like this usually come only on securities with high risk of dividend cuts, default, bankruptcy, etc. Yet that doesn’t appear to be the case here.

2. Very Reliable Distribution

1. ATP sells its power under very favorable long term Power Purchase Agreements (PPAs) to investment grade, established utilities with investment grade credit ratings that have never defaulted on a PPA.

2. These PPAs typically mitigate risk by:

a. Substantial capacity payments based on the plant’s availability (not on actual demand or output) generally structured to cover fixed costs, capital, return on capital, and energy costs and other variable costs.

b. Pass through of fuel cost changes to the utilities.

c. Most projects have long term fuel supply agreements that correspond to the length of the PPA.

3. ATP has a very geographically diverse project portfolio, thus limiting exposure to any individual utility, market, regional regulatory or environmental conditions.

4. ATP claims to generate cash in excess of that needed for ongoing operations and distributions to investors, thus ensuring stable distributions. Actions supporting this claim include:

5. In November ’08, while stock markets were hitting new lows, the company actually raised distributions 8%.

6. In October ’08, the company announced that as a result of new currency hedges, cash on hand and projected future cash flows from existing operations would be enough to cover distributions to IPS shareholders through 2015, without including new cash flows from the pending Auburndale power plant purchase or future acquisitions.

7. On July 23rd the company believed the shares to be such a good value that it announced it was repurchasing 4 million of the IPS or 8% of the total float, when the price was $US 8.53. This not only supported the share price, it also reduced outstanding debt from the bond portion of the retired IPSs.

8. Sector utilities can be very good bear market stocks because their power usage and hence revenues tend to be very stable even in bad times.

B. WHY NOT

Is this huge, safe dividend too good to be true?

1. High Payout Ratio:

Payout Ratio is the ratio of distribution to cash available for distribution after meeting needs for ongoing operations and existing obligations. Theoretically, the higher this is, the greater the risk of a dividend cut if the revenue stream falters.

Different industries have different levels of acceptable payout ratio. For example, Canadian energy trusts’ revenues vary with oil and gas, which can (and have recently been very volatile. Thus we like to see payout ratios below 70% (these days even lower). Since power companies tend to have very stable revenue streams, its acceptable for them to have higher payout ratios of around 80% or more.

As of September the payout ratio was in the high 80% range, and was recently reported to be almost double that for the fourth quarter. After repeated requests to the company’s investor relations department, I still haven’t gotten clarification on whether their payout ratio is as high as some have recently claimed (about 160%). I’d want to better understand how they can claim to so easily cover such a high payout ratio.

As mentioned above, the company claims it can and will cover the distribution to at least 2015. How can it be so confident with such a high payout ratio?

While I’m still checking, I suspect that there is a reasonable explanation for the 160% figure. Either it is either an error, or the figure is somehow distorted by some special condition here, either by the bond dividend portion of the distribution or some non-cash charge like depreciation expense (which can be very large for power companies) that should have been factored in but somehow wasn’t.

2. Market Risk

The price of the IPSs moves with the overall market, so if that continues to drop, so will the price. That’s unpleasant but not a problem as long as the distribution holds and you don’t need to sell.

3. Currency Risk

The distribution and unit price is set in Canadian dollars, and thus does vary with changes in the exchange rate with US dollars. That has both helped and hurt the shares. Overall I prefer the prospects of the Canadian dollar to that of the US dollar, so this is probably more of a bonus than a risk.

4. Liquidity/Thinly Traded

Average daily volume for the past three months is about 92,000 shares, and is usually below 60,000 shares. That means that it doesn’t take a lot of selling to drive the price down fast, as we saw at the end of ’08, and may yet see again in the near term. So again, this is not a stock for those who may need to sell soon. The benefit of this is that you can put in a lowball order another 20% below the current price and have a chance at getting it if the stock suddenly dives as it did in November.

5. Other Risk

The IPS bond portion is a subordinated bond, meaning there is more senior debt that gets paid first. As of September ‘08, there’s about US $340 million of it, compared to about $356 million of the IPSs’s subordinated notes. In a worst case scenario collapse, the IPS bond portion gets paid only after the more senior debt holders. Only after these does the common stock dividend get paid. This possibility seems remote even under current conditions, but it exists.

3. CONCLUSION

The above were my top picks in the best sector, Energy, for high dividend investors seeking reliable dividends between 7% - over 12% with excellent likelihood of capital appreciation within the next 12-24 months.

I also included a little known electric power fund that is really worth a look.

Unless the company has been outright lying, we have a rare case of a relatively safe 16% yield that is far greater than to the risks to the distribution or health of the company. The prices of the IPS units has varied with the overall market, and thus could conceivably drop a third or more as it already did in November.

So if you’re prepared to ride out the price volatility, Atlantic Power Corp seems to be one of the very best income plays available. ATP rates a buy up to USD $ 7.50 under these volatile conditions, a strong buy below USD $6.00.

What do you think? Comments welcome.

DISCLOSURE: The author holds positions in the above mentioned securities. For more on these and other high dividend stocks with reliable dividends backed by strong businesses, see http://highdividendstocksguide.blogspot.com.

Source: Top 10 Energy Stocks and an Overlooked Power Fund