Jubak's Journal
5 energy stocks for income investors
With bonds looking dismal, income investors need alternatives. Here are 5 picks for a new income-stock portfolio I'm launching.
By Jim Jubak
The U.S. Federal Reserve has made life a lot more difficult for income investors. Not only are yields low, as they have been for quite a while, but now income investors face a greater risk of losing capital. So what are you going to do about it?
Me? I'm launching a new portfolio, just for income investors, to help you navigate what has become an even more treacherous stock market. The goal -- and it's not as modest as it sounds -- is to find equity investments with yields above the 4.5% paid by the 10-year Treasury note currently and that are safer than the 10-year Treasury under current market conditions. In today's Part I, I'll pick the first five stocks for the portfolio.
For the last 15 months, ever since the Federal Reserve started to raise short-term rates, income investors have dodged a bullet. Alan Greenspan and Co. have raised short-term interest rates to 3.75% this September from 1% in June 2004, but long-term interest rates have refused to follow suit. Normally when the Federal Reserve starts to raise short-term interest rates in order to lessen the danger of future inflation, long-term rates start to edge up. But it didn't happen this time: The yield on the 10-year Treasury stood at 4.69% at the end of June 2004. After 11 short-term rate increases, it had fallen to 4.3% on Sept. 30.
Investors who had decided to risk their capital to get the higher yield on the 10-year Treasury had won their bet. Bond prices go down when interest rates go up. So if long-term yields had followed their normal pattern and climbed as the Fed raised short-term rates, investors who had bought 10-year Treasurys would have seen the value of their bonds fall. If the yield on 10-year notes had climbed to just 5.25% in a year from 4.69%, investors would have seen the market price of $1,000 in Treasury notes fall to $893.33. That 10.7% loss of capital would have more than wiped out the 4.69% in interest income paid by the note.See the news
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Confidence, reconsidered
Lots of experts have weighed in with explanations for why bonds didn't behave as they normally do -- why long interest rates fell while short interest rates rose. But here's the reason that's most important for investors over the next 18 months. Long-term interest rates didn't go up, this argument goes, because the bond market was convinced that the Fed is so smart and so powerful that it simply won't allow any increase in future inflation.
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I don't discount explanation No. 1, and that's what worries me and should worry all income investors. If long-term rates moved lower because the bond market thought the Fed had inflation under control, long-term rates will move higher if the bond market feels the Fed has lost control. And there's evidence that the bond market is at the least rethinking its belief that the Fed has everything under control.
Take a look at the bond market's reaction to a series of warnings from the Fed in the first week of October. The warnings culminated in the now infamous "virus" speech of Dallas Federal Reserve President Richard Fisher. The Fed can't "let the inflation virus infect the blood supply and poison the system," Fisher said.
Instead of being reassured by these remarks that the Federal Reserve was on the job and ready to do whatever it takes to stop inflation dead, the bond market proceeded to send yields on the 10-year Treasury steadily higher. The yield on the 10-year Treasury note closed at 4.45% on Oct. 12, up from 4.23% on Sept. 23. That has produced a 5.1% loss for bond investors.
My opinion is that after telling the capital markets for so long that everything was under control and creating the expectation that one or two more interest rate increases would do the job, the Federal Reserve has now succeeded in spooking the bond market by going public with these worries.
Two options, one solution
Knowing that Alan Greenspan's term as Fed chairman ends Jan. 31 only reinforces the bond market's doubts. Greenspan has said that he won't stay on after his term expires, which leaves the bond market contemplating life without the man it has come to rely upon since he took over as chairman in August of 1987.
I think income investors have two options here. First, you can hang in with whatever strategy and portfolio you currently have and hope that the bond market will dodge another bullet. Maybe long-term yields will pull back from their recent run up on fears of a recession, or the theory of a global savings glut will turn out to be true, or pension funds really are buying enough long-term Treasurys to keep yields low. Maybe the bond market will stop worrying about the Federal Reserve's ability to control inflation. And maybe President Bush will pull a great, confidence-building replacement for Greenspan out of his hat.
Could happen. But the odds that long-term yields won't be higher a year from now are worse than they were last year. And the odds that bond prices will be lower -- leaving bond investors with some dings to capital -- are greater than they were a year ago.
I prefer a second alternative: carefully laddering as much of my long-term bond portfolio as possible so that I can hold my long bonds to maturity, if I have to, rather than selling them at market prices (which might be lower), and moving some of my income assets out of bonds and into income stocks.
I think that's an especially attractive alternative right now. First, the sector of the economy that has brought investors heightened inflation worries -- the energy sector -- will be swimming in cash flow that can go to higher dividends if those inflation fears are correct. And second, energy stocks are currently selling for modestly lower prices in the stock market thanks to October's profit-taking.
Pass by the oil exploration and production companies in your search for stocks that fit my goal of higher yields and high safety. Big exploration and production companies like BP (BP, news, msgs) and smaller ones like Chesapeake Energy (CHK, news, msgs) are putting so much of their cash flow into finding and producing new oil that they can't pay out as much as I'm looking for in dividends. BP pays a 3.2% dividend yield, for example, and Chesapeake Energy just 0.6%. These are growth stocks that should go in your portfolio if you're looking for capital appreciation. But they don't make the grade as income stocks.
Masters of the dividend universe
To find higher-yield and high-safety income stocks, I'd look to two segments: pipeline master-limited partnerships and energy master-limited partnerships.
Pipeline companies such as TransCanada Pipelines (TRP, news, msgs) have plenty of growth ahead of them, thanks to the U.S. appetite for natural gas and oil and the need to develop and transport new supplies from Canada, Mexico and newly developed U.S. fields. But spending on those projects puts most pure pipeline companies in the same capital-spending category as the oil exploration and production companies. If you're spending money on capital projects, you can't distribute it as dividends. So, for example, TransCanada will invest about $180 million on its new pipeline in east-central Mexico.
Enter pipeline master-limited partnerships. These are collections of assets -- and their revenue streams and profits -- spun off by pipeline companies into high-yield vehicles. The spin-off can make it easier for the parent company to raise capital. It also certainly gives the parent company, which is the limited partner that actually manages the assets, a steady supply of fees and a hunk (sometimes too large a hunk) of the profits. But master-limited partnerships are structured as income vehicles for investors, too, with part of the income paid to investors sheltered from taxes until the shares are sold. And they pay the kind of higher yields I'm looking for with this portfolio. I'm going to put three in this portfolio: Kinder Morgan Energy Partners (KMP, news, msgs), with a 6% yield, Northern Border Partners (NBP, news, msgs), with a 6.9% yield, and Magellan Midstream Partners (MMP, news, msgs), with a 5.9% yield.
Energy master-limited partnerships work the same way pipeline master-limited partnerships do, except that the assets spun off are oil and gas wells or coal mines. I'd suggest two of these for my income portfolio: Penn Virginia Resources (PVR, news, msgs), with a 4.9% yield, and Natural Resource Partners (NRP, news, msgs), with a 4.7% yield.
I've left out Canadian royalty trusts, a north-of-the-border version of the U.S. master-limited partnership structure with a history of paying far higher yields than their U.S. relatives. I know this will raise howls of protest from income investors who have collected impressive income streams (and recently market-beating capital appreciation, too) over the years, but the current uncertainty over changes in Canadian tax law makes me hold my fire on these income stocks right now. There is simply too much uncertainty, especially at current high valuations, to take on right now. New rules are expected sometime in early 2006. I'd revisit these trusts then.Jim Jubak's newsletter
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These five income stocks, all from the energy sector, make up just half of what will eventually be a 10 income-stock portfolio. As much as I like the dividend power of the energy sector, I'm still not willing to put all my eggs in that basket. Part 2 of this income-stock portfolio will add diversification by picking five stocks from other sectors. At that point, I'll start tracking this 10-stock portfolio publicly via a link you'll be able to find in my column. Expect Part 2 in November.
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New developments on past columns
6 stocks for a second-half growth rally
After the stock market closed on October 12, Komag (KOMG, news, msgs) upped its earnings and revenue guidance for the just-completed third quarter. When it releases official financials after the close on Oct. 26, the company now expects to report revenue of $180 million, above the Wall Street consensus of $175 million. A shift in the mix of products sold toward higher margin 100GB and higher-capacity disks has pushed average selling prices higher. Net margins, the company said, will expand to 17% to 18% in the quarter from the previous guidance of 16%. All this is very good news for what is a transitional quarter as the company adds new manufacturing capacity to meet demand that has filled existing factories to capacity. The stock market, determined to sell off everything right now, doesn't seem to care. But Komag is, in my opinion, a technology stock with fundamentals worth waiting for. The market will recognize them eventually. As of October 14, I'm keeping my price target of $48 by December on these shares. (Full disclosure: I own shares of Komag.)
Editor's Note: A new Jubak’s Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, , Jim Jubak owned or controlled shares in the following equities mentioned in this column: Komag and TransCanada Pipelines. He does not own short positions in any stock mentioned in this column.
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