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3 rules for investing in scary energy stocks
Iffy accounting, dismal credit and frightening volatility have chased most investors away, but value experts see bargains -- if youre careful.
By Michael Brush
With the threat of heavy-handed regulators and bankruptcy in the air, former high-flying energy traders such as Mirant (MIR, news, msgs) and Dynegy (DYN, news, msgs) have been crushed to well under $5 -- Wall Streets equivalent of a going out of business sign.
Down at these depressed levels, however, several smart value managers are snapping up these energy merchants -- companies that operate pipelines and transmission systems and buy and sell energy supplies such as electricity, natural gas or oil. The reason: The hard assets, such as power plants and pipelines, could be worth more than the market value of the companies that hold them, even after you factor in their huge debt loads.
Should you follow the value guys? Yes, if you can understand and handle the fundamental risks, and then follow three basic rules of investing in this group. (Well get to those rules in a moment.)
Everybody thinks all of these companies are like Enron (ENRNQ, news, msgs), but it just aint so, says Marty Whitman, who manages the Third Avenue Value Fund (TAVFX). Thats a reference, of course, to hidden bombs in Enrons financials that eventually took the stock out. Whitman doesnt believe similar problems lurk in the books of Aquila (ILA, news, msgs), so he recently added it to his portfolio. I think the odds are at these prices, I have a ten bagger.
We are in this panic mode where the Wall Street analysts and the credit rating agencies are being too cautious, and any tainted stock is getting destroyed, agrees John Buckingham, a portfolio manager with The Al Frank Fund (VALUX). Frankly, I think there is a lot of opportunity.
Even value investing titan Warren Buffett recently entered the sector, through the purchase of pipelines from Williams (WMB, news, msgs) and Dynegy. I would be more inclined to follow Buffett than the Wall Street analysts, says Buckingham. I equate this to the savings-and-loan crisis of the late 1980s. Back then, we were buying every savings and loan we could find.
Three key rules
Which now brings us to the three rules for investing in beaten-up energy merchants:
Rule 1: Buy lots of them. The idea is you buy a basket of them, and you have the patience to stay with it. Clearly, you are not going to see all of them go out of business, says Buckingham. But some probably will. Hence the need to buy a half dozen companies in the group. The Al Frank Fund owns Mirant, Calpine (CPN, news, msgs), Aquila, Dynegy, Williams, and Xcel Energy (XEL, news, msgs). Another one popular among the value players is El Paso (EP, news, msgs).
Rule 2: Dont put too much money to work in this group. I cant stress this enough, you have to buy only small amounts, says David Dreman, who manages the Scudder Dreman High Return Fund (KDHAX). You have to buy a little of a bunch. If you did that during the savings-and-loan crisis, you made money. Managers like Buckingham and Dreman have less than 1% of their portfolios in these stocks. Aside from El Paso, which is the blue chip, the rest are highly speculative, Dreman says.
Rule 3: Hold on long enough so your gains from the winners more than make up for the ones that disappear. You should expect some of these stocks to tank. But the companies that survive will, in the long run, provide generous returns. The key to success is patience, given the group's volatility. When these stocks go up 200% to 300% in a few days, it is tempting to take profits, says Buckingham. But he says he has taken his positions with a three- to five-year time horizon. Likewise, be prepared to stomach sharp moves to the downside. Aquila shares got cut in half just last week after the company announced it had drawn down a credit line and made some accounting adjustments.
The group may be too speculative
To be sure, many industry experts say the group is still too risky and advise investors to steer clear. They are still quite speculative at this point, says Bala Dharan, J. Howard Creekmore Professor of Accounting at Rice University, who has testified before Congress on accounting problems in the group. It is not clear to me that these are perfect entry points.
We prefer not making money in them to the risk of losing a boatload, agrees Paul Abel, manager of the Kinetics Energy Fund (ENRGX). We dont see enough clarity in the situation.
George Putnam, of the Boston-based Turnaround Letter, suggests anyone venturing in should buy debt instead of stock. In bankruptcy, before the stockholders get anything, bondholders have to get paid off," he says. "So there is less risk with the bonds than with the stocks.
Here are the things that trouble investors about the sector, and why the value investors think they may not really matter -- in the long run:
Credit problems
Back in the heyday of power-market deregulation, energy merchants loaded up on debt to build more power plants and buy more pipelines. They enjoyed solid credit ratings, which reassured parties on the other side of complex and profitable energy trades.
Then, the economic slowdown curtailed business because it reduced demand for energy. And accounting disasters at Enron and Worldcom (WCOEQ, news, msgs) made credit rating agencies such as Standard & Poors and Moodys become more vigilant (some would say more paranoid). Theyve since cut the debt of energy merchants to within an inch of junk status. And they might keep going. That could trigger faster debt payments, which would force energy merchants into bankruptcy, wiping out the stocks. The wild card in all this is the Moodys witch hunt, says John LaForge, portfolio manager with the Phoenix-Hollister Value Equity Fund (PVEAX).
Already, though, the credit downgrades have curtailed once-profitable energy trading operations -- not to mention all that borrowing which was supposed to fund rapid growth. This alone might make it hard for these companies to pay off all the debt they took on, LaForge says, again, forcing some into bankruptcy.
Though some hedge funds disagree, at least there probably arent more disasters stemming from hidden off-balance-sheet lending operations like the ones that got Enron into trouble, says Rice Universitys Dharan. Al Franks Buckingham thinks Mirant looks the safest when it comes to credit quality. El Paso also appears strong, says Dreman. As for the rest of the group, both analysts are betting the credit agencies are overreacting and wont have to push the energy sector over the edge with more downgrades.
Asset fire sales
Desperate to raise cash, energy companies are dumping assets such as pipelines and power plants on the market as if it were a giant used car lot. In many cases, theyre getting a lot less than they paid just months ago. This will make it harder for energy merchants to dig themselves out of their holes. But in general, their assets are still worth more than whats reflected in their share prices, say value managers who own the group.
What about those trading books?
When their trading operations were still going strong, energy merchants booked complex agreements to deliver power years into the future -- based on assumptions about things like the price of coal and natural gas, the availability of transmission lines, and even weather conditions. Now, as they close down those trading operations, they have to unwind those complex long-term deals. Theres a risk they may find costly surprises. Their trading books, in other words, could still blow up.
Even if they dont, many of the trades are so complex it's hard for outsiders to know what they are worth, or how much they will end up costing, says Dennis O'Brien, the director of the Institute of Energy Economics and Policy at the University of Oklahoma. We dont have the level of detail that we need, and we dont think anyone does, admits Buckingham. That is why you dont put all your eggs in one basket when you invest in this group.
Some experts, however, suspect there arent too many disasters lurking. This has been way overblown. There is not as much risk as you might think. A lot of the bad news is out, says Peter Fusaro, co-author of What Went Wrong at Enron: Everyone's Guide to the Largest Bankruptcy in U.S. History.
There is no question there are some accounting problems, says Dreman. But not Enron-type problems. There is no evidence they are really that bad. It is just a matter of how you value these contracts.
The regulation threat
If governments step in and control prices -- in response to the embarrassing electricity market snafus in California last summer -- that would kill off the need for most merchant energy trading. After all, what good are traders when there is no price volatility?
Insiders, however, dont see it shaping up like that. I think energy merchants have a definite role because the logistics are much too complicated not to have a middle man in there making the system efficient, says Richard Duszynski, chief executive officer of Sequent Energy Management, which handles energy trading for its parent company, AGL Resources (ATG, news, msgs). However, Duszynski thinks the trading business will be smaller because it will focus more on physical assets, as opposed to complex trading instruments that guarantee future delivery.
I dont think the energy trading business will go away, agrees Michael Stosser, a former Federal Energy Regulatory Commission attorney who now follows energy regulations at Heller Ehrman, a Washington, D.C. law firm. But the new rules shaping up will lead to less volatility, he thinks. Again, that would limit the potential profits at energy merchant trading desks.
Investors in these companies also face the risk they may have to give money back to California and other governments, which vastly overpaid for electricity last summer when the market got out of whack. Meanwhile, the Securities and Exchange Commission is looking into accounting practices.
Like other value investors who own shares in these firms, Al Franks Buckingham thinks these threats are already priced in. The market has already discounted all the bad news, and then some. There is such negative sentiment, a lack of more bad news could cause these stocks to rally.
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