3 sectors that could provide diamonds in the rough

PIMCO's Mark Kiesel offers investors a starting point for thinking about what might work out in the current investment climate.

By The Fiscal Times Aug 7, 2012 12:43PM
By Suzanne McGeeThe Fiscal Times

In this kind of market environment, it not only pays to be picky -- you simply can't afford to be anything else. And nowhere is that more true than the bond market, given the extent to which yields have been compressed since the financial crisis struck almost exactly four years ago.

Investors want the qualities that bonds offer -- the guarantee of some kind of return in the shape of regular interest payments, a.k.a yield, along with safety in the form of the first call on assets in the event of a bankruptcy. But in far too many cases, the yield simply isn't adequate to offset even the lower risk associated with these securities. And when it is -- well, every other investor is eyeing it avidly, too, so odds are that it won't stay attractively priced for more than a fleeting second.

So, what's a wannabe bond investor to do? The trick -- obviously enough -- is to get in ahead of some of the rest of the crowd and to be very picky. Or, as investment pros like Mark Kiesel of Pacific Investment Management Co., better known as PIMCO, prefer to put it, "selective."

Kiesel has come out with a list of themes and companies that he appears to believe can be grouped together under the label of "diamonds in the rough" -- "asset-rich companies with solid balance sheets that are currently benefitting from improving fundamentals" and that are supported by factors as varied as "demand growth, improved market discipline, capacity reductions, high barriers to entry, supply constraints, efficiency gains, material cost advantages" and so on.

Now, there's nothing remotely like rocket science or alchemy going on here. Kiesel simply has done enough digging to identify a few companies with the characteristics that always have generated outperformance by a company's stocks or bonds. And while he has honed in on several different sectors, it's worth being a little more finicky still and figuring out whether some might prove more alluring than others, at least in the immediate future.

Kiesel suggests that investors look for bonds issued by LyondellBasel (LYB) and other big chemicals companies who stand to profit from natural gas producers; the United States has now become a low-cost producer of ethylene. Then there have been signs of a long-awaited pickup in the housing market, which leads him to companies like Weyerhauser (WY), a player in both the timber/lumber industry and in real estate. The order backlog is growing, Weyerhaeuser has reported, while unsold inventory is falling -- a good combination.

Here, three other sectors highlighted in the PIMCO report:

Gambling on Macau
Whether it's a well-heeled Chinese businessman traveling to the casinos to play poker or an elderly grandmother wagering heavily on a ferocious neighborhood game of mahjong, the rise of a Chinese middle class has enabled far more to pursue their passion for gaming, and, as Kiesel points out, the Chinese government has been enabling that addiction by spending heavily on infrastructure -- highways, bridges, high-speed trains -- that will allow them to get to Macau more rapidly. A company like Las Vegas Sands (LVS) may bear a moniker tied to the heart of high-stakes gaming in the United States, but now generates 90% of its earnings before interest, depreciation and taxes from its holdings in Singapore (another big center of Chinese gaming) and Cotai, an area in Macau, as Kiesel explains. He notes that less than seven years ago, Vegas and Macau generated roughly equal revenue for gambling establishments, but today, while the Vegas strip's revenue hasn't changed much, that of Macau outstrips it by a six to one ratio.

Ready for takeoff?
Other sectors recommended by Kiesel will require a greater leap of faith, however. It has been many years since the airline industry rewarded its fans, and even now the fact that capacity appears to be declining while load factors and revenue per mile flown are rising may not be quite enough to compensate for the risk that consumers will balk at higher fares and, in the case of the higher-revenue business travelers, opt to stay home. True, Kiesel isn't proposing that you go out and snap up stock in the airlines themselves, but rather than investors look for higher-quality bonds tied directly to the aircraft, known as enhanced equipment trust certificates. These give their owners a direct interest in the aircraft (look for those tied to the most efficient new aircraft, Kiesel suggests, or planes that are vital to an airline’s business) and additional layers of security. Still, the airline industry is in near-constant turmoil, and it's also economically sensitive. Perhaps only for those with level heads and strong stomachs?

Profits in pipelines?
The pipeline industry is one with very appealing fundamentals right now. The facts are very straightforward: Across North America, crude oil and natural gas is trapped, unable to be transported to markets that are eager to use it. That has caused some distortion in fuel prices, with natural gas prices in some regions plunging simply because storage reservoirs are crammed with gas for which there isn’t room in pipelines. The problem is particularly acute in some of the areas where producers are discovering new reservoirs of oil and gas in shale formations -- the Marcellus and Bakken shales, for instance. Some of these new discoveries end up being "shut in" -- or not exploited -- simply because for now, at least, there's no way to get the supplies from the wellhead to the market. Over time, this certainly will change.

But profiting from the pipeline industry can be tricky, given the kerfuffle surrounding the fracking technologies that will be required to extract some of these new supplies, and the persistent debates over the construction of new pipelines. For instance, environmental activists are fiercely opposed to the Keystone XL pipeline that would transport crude oil products from the tar sands in northern Alberta, Canada, into the Midwestern U.S. President Barack Obama declined to fast track the permits required to build the project, and the State Department is exploring alternative routes. That incident serves as a reminder of how regulated and how politicized this industry is, and thus the extra layer of risk attached to any investment -- however well covered the bonds might be.

Kiesel's ideas -- the public report doesn't include many specific company names -- do offer investors a starting point for thinking about what might work out in the current investment climate. It's also a timely reminder that just because sovereign debt is trading at or close to negative real returns (at least, in many parts of the developed world), that doesn't mean that investors should turn up their noses at all fixed-income securities. Just don't view his suggestions as a shopping list. They're simply a starting point for discussion, and some ideas where a very, very picky investor might concentrate some of his research.

Suzanne McGee is a columnist at The Fiscal Times. Subscribe to The Fiscal Times' FREE newsletter.

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