Monday, December 19, 2011

the troubled utility cycle

Any investors should realize that there are four main stages in so called “troubled utility cycle” in order to do right timing entrance and exit for those types of investments. The first stage is disaster strikes. It is faced with a sudden loss in earnings, either because of some huge cost which it could not pass through to its customers, or because a huge asset (such as a new plant) is “mothballed and removed from the rate base.” Its stock would lose around 40%-80% of its value in one or two year period. As investors experienced the drop in the share price, they would no longer felt the utilities as a safe and stable investment. The price keeps falling, and it might trade as low as 20-30% of the book value. The time to stay at that low market depends on each disaster. Lynch cited that in the Long Island Lighting case, the bankruptcy threat made the stock at 30% of its book value for four years.

The second stage is “crisis management.” A utility business would respond to its disaster by cutting capital expenditure and adopting austerity budget. Normally in this period, the dividend would be eliminated in order to bring strength back to its financial structure. At this stage, there would be no reflection on its stock price yet.

After that, the business would come to “financial stabilization.” When it had succeeded in cutting cost, the utility begin to generate enough cash for its own operation. Although it might not earn anything for the shareholders at this stage yet, survival was almost the certainty. The stock price of this period might move up to 60-70% of the book value.

Last but not least, the stage four is that the recovery is recognized. The utility business is capable of earning something for its shareholders, and Wall Street begins to expect improved earnings and the continuation of its dividend. The price of its stock moves up to its book value. So what would happen afterwards? He noted: “How things progress from here depends on two factors: (1) the reception from the capital markets, because without capital the utility cannot expand its rate base, and (2), the support, or nonsupport, of the regulators, i.e, how many costs they allow the utility to pass along to customers in the form of higher rates.”

When recognizing the utilities pattern, employing the good strategy to reap the benefits from investing in utilities is not an issue anymore. Lynch advised people to buy on the omission of the dividend and wait for the good news or investors could wait for the good news to come in the second stage, and then buy the stock. Even when the stock has doubled, a lot of people might think they have missed the bottom, but troubled utilities have a long way to go. “A simple way to make a nice living from troubled utilities: buy them when a dividend is omitted and hold on to them until the dividend is restored. This is the strategy with terrific success ratio.”

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