The Roman god Janus looks both ahead and behind at the same time. With his namesake month January days away, now’s a good time to look at a few things income investors learned in 2009, and what they portend for the year ahead.
Without a doubt, the best news about 2009 was that income investments of all stripes prospered. Canadian trusts, master limited partnerships (MLP), utility stocks, telecoms, small banks, Super Oils and even real estate investment trusts (REIT) were well in the black. The magnitude of the gains is even more astounding considering the markets continued to fall during the first two months of the year before bottoming in March.
The worst news is that many income investors didn’t take full advantage. In fact, more than a few found the pounding of 2008 and early 2009 too much to take, cashing out of their holdings at precisely the wrong time.
That brings up lesson No. 1 of 2009, which applies to investors of all stripes: Never give up on positions as long as underlying companies paying the dividends are still healthy. Things did look bleak at the March bottom. But 10 months later, the healthy have rebounded, some to levels well above where they were the day Lehman Brothers (OTC:LEHMQ) fell and the great collapse of 2008 began in earnest.
In contrast, companies that faltered as businesses in the face of the historic stress tests are still deep in the red and may never recover. But buyers have come back to companies that held revenues steady and balance sheets strong have recovered in full.
It was certainly tempting to throw in the towel many times in late 2008 and early 2009. And this market has certainly had to climb a tall wall of worry ever since. But investors who hung in there have climbed back faster than even the most optimistic could have anticipated.
If you were one of those who headed for the hills at the wrong time, don’t despair. There’s still time to build positions in good companies backed by strong businesses that are still selling cheaply and paying big dividends. Just don’t try to make it all back in a hurry, and keep an eye on what you’re paying for stocks.
Also, it’s only natural that we should expect to see some kind of pullback in 2010, and it may leave newly entered positions underwater for a time. If that happens, staying focused on the strength of underlying businesses will again be critical, as will holding onto positions as long as they remain strong.
An equally important lesson of 2009 is that too much debt can kill. The big banks have stabilized well ahead of even the most optimistic forecasts, paying off their loans from the federal government.
That’s in large part due to their desire to pay bonuses, which are needed to keep key personnel. But it’s also a good sign that this industry--which was at risk to going under just a year ago--is now open for business again.
What has some in Washington flummoxed is that, despite their improved financial health, bank lending is nowhere near its pre-2008 crash levels. That’s because, like the post-Enron crash of the power industry in early 2003, banks are refocused on risk.
Institutions have no problem lending to their most creditworthy customers at some of the best rates in decades. But consumers and businesses that really need to borrow money are still having trouble getting funds on good terms, unless they’re able to demonstrate improving health. In short, banks are loath to take big risks.
The same thing is true for other types of corporations. A year ago, the corporate bond market was frozen. Even A-rated utilities were forced to pay out yields 500 basis points or more above their “risk-free” Treasury bond equivalents. Companies rated less than investment-grade would have been better off panhandling than issuing bonds.
Over the past year, however, those yield spreads have shrunk to their lowest levels ever, as investors have lost their fear of buying them. At the same time, benchmark Treasury rates have fallen to their lowest levels in years. The upshot: a buying frenzy for investment-grade bonds of all types that’s pushed yields to their lowest levels in decades.
Generous lending rates have even extended to some of the companies in the non-investment grade, or junk, arena. Even startup enterprises like WiMax venture Clearwire Corp (NSDQ: CLWR) have been borrowing at reasonable rates despite severe headwinds to their prosperity.
The upshot is the lowest bond yields in decades for high-quality corporate bonds. That makes now probably one of the worst times in memory to buy into corporate bonds, particularly long-maturity paper that’s exposed to interest rate swings. Yields are just too low to compensate for any risk.
Low bond yields, however, add up to higher earnings and improved balance sheets for the corporate issuers. They also mean cheaper money to finance acquisitions and other expansion to spur future growth. The plunging cost of capital, for example, is set to fire up distribution growth for stronger MLPs such as Enterprise Products Partners LP (NYSE: EPD) by making a whole range of new infrastructure projects profitable.
On the other hand, no one should count on lower borrowing rates to ride to the rescue of financially weak companies. I’m not so concerned about companies rolling over large amounts of debt in the next year or so, as borrowing rates are now very low. And companies with big borrowing needs, like Frontier Communications (NYSE: FTR), have definitely caught a break.
Last year, when FairPoint Communications (OTC: FRCMQ) closed the purchase of Verizon Communications’ (NYSE: VZ) rural phone lines in northern New England, it was forced to borrow at loan-shark rates. That was single biggest factor in its eventual bankruptcy, which will all but wipe out its shareholders.
In contrast, Frontier continues to roll over debt at money-saving rates while pushing out its maturities. Its credit rating is on watch for upgrade by the major raters, even as management says it expects Federal Communications Commission (FCC) approval of the deal in February.
The company also received an early Christmas gift on December 24 from the staff of the Washington Utilities and Transportation Commission, which reversed its previous opposition to the deal. Frontier in return agreed to invest $40 million Internet access, a condition it would likely have met on its own as rural telecoms’ salvation lies in up-selling such services.
What I am concerned about, however, are companies whose credit terms seem to be worsening. And I strongly advise sticking to the financially strongest companies in any sector you choose. That’s particularly true of sectors that are still in the weak spot of this economy, including mid-sized banks, owners of commercial real estate, homebuilders, timber companies and heavily indebted industrial concerns.
If a company has stayed healthy over the past several years, odds are it’s going to stay that way, if not get much stronger in 2010. But if a company is weak and appears to be still weakening, a slowly improving economy is not going to be a tonic. Avoid.
Undone by Unemployment
Worries about a lack of capital were a major factor behind the corporate downsizing of 2008 and 2009. But even with capital aplenty, companies have been slow to apply their staff back up.
In fact, most seem to have learned they can get by with fewer employees, evidenced by the huge gains in US productivity measures in the second half of the year. New hires are only made when necessary, as management holds to conservative forecasts and business models.
This new conservatism is a necessary step toward a stronger economy. In the near term, however, is means high unemployment. That, in turn, has kept consumer-dependent sectors of the economy on the weak side. And that’s put particular pressure on companies with high debt loads.
Many expect loan defaults to hit new highs in 2010, particularly in real estate as the impact of government support wears thin. Commercial real estate also looks vulnerable, with many of the key players highly leveraged and property values seemingly still sliding.
Regulated utilities mostly sailed through this recession for two reasons. First, they’ve been in a rapid de-leveraging mode since the Enron crackup and boast their strongest balance sheets in decades. Second, the very nature of their business--essential services--means revenues are steady even under the worst economic conditions.
Utilities, though, also have a point of vulnerability as long as unemployment stays high. Mainly, regulators are loath to grant rate increases, even those needed to pay for vital infrastructure. Thanks to a decade of working together, most states aren’t really socking it to utes at this time. But companies in most states have had to accept lower boosts at least temporarily in order to lessen the shock on consumers.
Most alarming have been developments in Florida. Over the years, the state has established a regulatory environment conducive to long-term planning by utilities. That’s allowed companies like FPL Group (NYSE: FPL) a low cost of capital, critical to providing for a continuously growing population in a climate known for hot temperatures and violent storms.
This year, however, Governor Charlie Crist sacked an experienced Public Service Commission and replaced it with a group of novices that owe their political loyalties to him alone. Crist’s motives are certainly nothing the utility industry hasn’t seen before: He’s running for the US Senate in 2010, and consumers are angry about utility rate increases in a recession.
For investors, however, this is a clear warning that the regulatory security we’re used to in the Sunshine State is no more. I still like FPL, which is the nation’s leading wind and solar power company and derives more than half of its income out of state. But those in Progress Energy (NYSE: PGN) or TECO Energy (NYSE: TE) need to keep a close eye on how the new commission decides rate cases this year.
So-called pro-consumer pandering does eventually hit the consumer with higher rates, as utilities’ cost of capital rises. That’s a big reason why the cost of electricity is so much higher in the so-called pro-consumer states of the Northeast than in the pro-business Southeast. But in the meantime, it can certainly hit those who own affected companies.
The upshot is there’s still a lot of danger out there. And it’s still critically important for income investors to avoid highly leveraged situations. In fact, it’s a good idea to stay away from the highest yield in any investment sector.
There’s a reason for any yield that’s well above its peers in an industry, and that’s additional risk. Yield-seeking investors may be less concerned about weak companies in their quest for a big current dividend, and the risks have receded somewhat as the overall economy and the financial system have stabilized. But there’s still danger, and the market doesn’t lie. The highest yield in any industry is always the most at-risk. And as all too many investors have learned time and again, when a payout is cut, your principal comes right down with it.
Emotion Is the Enemy
Based on my conversations with investors over the past year, politics was a major reason many were underinvested last year. That brings me to another key lesson of 2009: Never let your political beliefs affect your investment decisions.
The US isn’t the only country where politics are an emotional subject. There’s nothing wrong with being passionate about your beliefs or your political party of choice. And almost no matter what your passions are, there’s a television or radio station that features talking heads who will say what you want to hear, and as long as you want to hear it.
Emotion, however, has absolutely no place in investing. That’s why it’s so disturbing to me to hear investors citing a political diatribe they’ve just heard as the basis for an investment decision. There’s no better formula for disaster, particularly in a political environment that has become so partisan and where opinion so routinely is passed off as news.
A case in point concerns an income investment that was extremely profitable in 2009 and looks set for a solid 2010: MLPs. MLPs are basically set up to pass through pre-tax cash flow to investors as distributions.
The tax burden is at the investor level, which allows MLPs to pay large yields and easing their ability to raise capital. And most of the distribution is sheltered on the investor level as well as return of capital, which is subtracted from the cost basis of the MLP rather than taxed in the year paid. Tax can in fact be postponed indefinitely if an MLP is included in an estate, as the heir’s cost basis automatically adjusts to the current price.
Most MLPs buy, build and operate energy infrastructure. Some, however, are financial constructs set up to skate around the edges of the law by using the concept of “carried interest” to shelter income from taxes. This group has been targeted by Congress and the Obama administration for a crack down and, this month, the House of Representatives passed a bill doing just that.
Immediately, however, The Wall Street Journal published an editorial with the patently false claim the House bill targeted all MLPs and REITs, whose investors could face a new “133 percent tax.” The Journal, of course, has been a leading cheerleader against anything coming out of Washington lately. So it’s no great wonder they would take liberty with the facts.
What’s tragic is that--judging from some of email my co-editor Elliott Gue and I have been receiving at our advisory MLP Profits--at least a few investors seem to believe them enough to consider dropping positions in solid MLPs.
Rest assured, we’ll be taking advantage of any weakness in our favored energy infrastructure MLPs that results from misguided selling. And we’ve been well out of everything that smells of carried interest.
Another case in point is those who bailed out of the market in early 2009 due to fears of what President Obama would do to the economy. To be sure, the new administration has been quite active, and many are unhappy with its actions. But by aligning their investment strategy with their politics, they locked in the horrific losses of late 2008. And they locked themselves out of the V-shaped recovery in the market that was one of the most dramatic in history.
Even a casual surfing of political talk television is enough to see that partisan rancor has hardly cooled in America. And there’s no shortage of reasons for emotional investors to make wrongheaded decisions because of their political views.
Front and center is the health care bill, which now appears headed for the president’s desk before his State of the Union address next month. However one stands on this issue, the debate on this bill long ago stopped being about health care, but about the future of the Obama administration itself. Senate Republicans knew that if they succeeded in blocking health care legislation, the president would be mortally wounded before his first year had ended.
As good politicians, they went at it tooth and nail. Unfortunately for them, their strategy has now failed spectacularly. Not only were their supporters and campaign donors’ interests completely left out of the most important piece of legislation for their industry in decades, but the Obama administration and Democrat-controlled Congress are reinvigorated and certain to push their other key objectives, namely financial re-regulation and carbon dioxide (CO2) regulation.
How successful they’ll be remains to be seen. On the CO2 front, Congressional inaction alone won’t stop regulation, as the Environmental Protection Agency (EPA) has declared the gas harmful to human health and therefore within its purview to regulate. In fact, EPA’s actions have caused the power industry and others to redouble their efforts to get Congress to act on legislation that sets clear rules on cutting emissions that make economic sense.
Financial reform, meanwhile, seems to have bipartisan support in the US Senate, typified by the budding alliance between Senators Mark Warner (D-VA) and Bob Corker (R-TN).
Whatever happens in the reality of Washington, the upshot on the airwaves is already being heard loudly on both sides. And judging from the growing number of concerned e-mails I’m getting about a dollar meltdown and an economic calamity arising from health care legislation, a growing number of investors seem to be in danger of letting their emotions get the better of them.
I said it in March and I’ll say it again: A well-constructed portfolio of securities of companies backed by good businesses will keep paying solid distributions through even the worst possible environment. Prices of even the strongest may take hits, as we saw in late 2008. But when conditions do improve, quality companies recover, and usually a lot sooner than almost anyone expects.
Conversely, weak companies--no matter what market they’re in--are always at risk. We can have the most favorable environment for business in the history of the world, and they can still fail.
Watch the Slack
My final lesson from 2009 is simply to watch the economic slack. In the early 1990s, I worked on a book with Dr. Stephen Leeb, Market Timing for the Nineties. In one of the chapters, “Big Declines are Bullish,” we analyzed every dramatic selloff in the market to that point since World War II.
The most important takeaway is that almost every time the market’s sold off more than 10 percent in a matter of a few weeks, there’s been a dramatic recovery. The chief reason is that sudden wipeouts of wealth create slack in the economy, eliminating the risk of overheating and providing room to grow without inflation.
Inflation was no doubt the furthest thing from most people’s minds for most of 2009. But it certainly was in mid-2008, when oil prices were pushing past $150 a barrel and prices of other commodities were surging. And the crash basically wiped out that inflation risk, creating room for the economy to grow once the financial system was stabilized.
Today the economy is well on its way to recovering, but there’s still enormous slack. That means, despite the gains we saw in 2009, there’s still a lot of upside for 2010.
Since the fall of Lehman Brothers in September 2008, income investors have basically faced a split market. On the one side are US Treasuries, still considered the safest of all yield investments. On the other is pretty much everything else.
On days when the economic news is bad, Treasuries rally and everything else drops. That includes utility stocks, despite the fact that they’ve proved themselves over the past two years as impervious to recession. On days when the economic news is positive, Treasuries drop and everything else rises.
That’s the pattern that will prevail until the US economy has definitely turned the corner, soaking up the slack. As long as there’s slack, there’s simply no way inflation can get off the ground. Any uptick in interest rates--mortgage or corporate borrowing rates--will be contractionary, prolonging the cycle until the economy does recover.
As long as inflation doesn’t get off the ground, income investors’ main challenge will still be ensuring every one of their holdings has an underlying business that’s healthy and growing. The good news is improved third quarter earnings attest that the strong are indeed getting stronger.
We’ve still got more gains ahead for stocks and other securities backed by strong underlying businesses. They’re not likely to be as dramatic as the returns of 2009, with the markets and economy coming off some of the worst conditions since the Great Depression of the 1930s.
But for those looking to build wealth and garner high yields along the way, that’s very good news indeed.