It's time to make a couple changes in our model portfolio. Let me explain why.
We want to own energy, but I want to raise our exposure in the crude sector and reduce our exposure to natural gas. With crude finding support at $60, we should shift out of two of our CanRoy holdings, Advantage Energy (AAV) and PrimeWest Energy (PWI), because they both have a production mix of 70% gas and 30% oil.
If gas prices remain under $5, then the dividends will probably be cut sometime early next year. The payout ratios of both are pushing up against 100%, while natural gas storage is at record levels -- and I just don't want to have to get on my knees and pray for a cold winter as part of my investment process.
Of course, I very much want us to hold each and every position for three to five years. It would make my job a lot easier, but it's the nature of the beast that I have to call it the way I see it -- and at this juncture, ramping up our crude weighting and reducing our gas weighting makes sense for the short, intermediate and long term. Putting it simply, managing risk is the name of the game, my friends.
When we got out of Frontline Ltd. (FRO) in August, with a modest gain, there were conditions that were (in my view) becoming geopolitically unfavorable. Those events led me to recommend getting out of Frontline at around $42, because I didn't want exposure to the risk of disruption in oil transfer in the Middle East if the Iranian/UN nuclear standoff led to sanctions -- which could have been followed by Iran making good on its threats of disrupting the flow of crude. Even if that threat hasn't happened yet, I still believe we were right to exit when we did and we've seen Frontline continue to slide to below $39 since then.
I know selling AAV and PWI involves booking a loss, but here's the logic:
When a sector goes through a massive correction, everything gets hit -- even the cream of the crop. And when that happens, smart money stays in the sector, but switches out of second-tier names and into first-tier names. This is true because, when the sector recovers (and it will), fund managers will jump on the highest quality names first -- and that's what I expect to happen here.
By selling Advantage Energy and PrimeWest, and using that cash to invest in two new Energy Trusts, we raise our exposure to the crude market and upgrade the quality of our holdings. The idea is that we maintain our long-term weighting in the energy sector, but when the market affords us the opportunity to upgrade that exposure, we're going to exploit it.
Oil, on the other hand, has seen demand steadily outstrip supply and is susceptible to spikes from geopolitical events. That's why I want us to stay invested in CanRoys in the energy patch with a higher exposure to oil prices.
Two of my favorites are Penn West Energy (PWE) and Provident Energy (PVX). Both have a production mix of 50% oil and 50% gas, and carry much lower payout ratios -- with PWE at 79% and PVX at 62%. Currently PWE is yielding 10% and PVX is yielding 11.2%.
Penn West Energy Trust (PWE) is the largest conventional oil and natural gas producing income trust in North America. By March 31, 2006, Penn West's production averaged 96,713 boe per day, of which just under half of that production was natural gas.
Penn West is based in Calgary, Alberta, and operates in five core areas throughout the Western Canada Sedimentary Basin. On April 16, 2006, Penn West Energy Trust and Petrofund Energy Trust announced that they had entered into an agreement that provided for the combination of Penn West and Petrofund to create the largest conventional oil and gas trust in North America with an enterprise value of more than $11 billion.
Provident Energy Trust (PVX) is the only Canadian energy trust with investments in oil and gas production, and energy infrastructure. Provident's Midstream business unit is Canada's second-largest integrated natural gas liquids business.
Midstream is a business with long-life physical assets (plants, pipelines, storage facilities, etc.) that provide an excellent balance to Provident's upstream production business units. PVX's integrated portfolio strategy provides excellent sustainability and a balanced-risk portfolio, both of which support our ultimate objective: long-term value.
So, make the swap by selling your AAV and PWI positions, and move that cash into PWE and PVX. We'll have two stronger names working for us when the sector rebounds.
Remember our buying strategy: Calculate the total dollar position you want to take in these two investments and then buy them in one-third positions on down days. That's the way I manage my portfolios and that's the way I want you to manage your 25% Cash Machine portfolio. We'll be proactive when it's prudent.
The other move I recommend making today is selling New Century Financial (NEW). My reasons for this trade is that NEW is a sub-prime lender with a lot of exposure to the no-down-payment, interest-only, adjustable-rate mortgage marketplace in the mortgage lending sector. It makes its money on yield spreads, borrowing short and lending long. With the yield curve so flat, that task is very difficult, not to mention NEW's clientele is the most likely to default on a mortgage if the economy falters and slips, or goes into a mild recession.
I recommended buying NEW back at the very beginning of May when the yield curve was steeper than it is now. In fact, the REIT had just come off a banner quarter and had raised its dividend. But during the past five months, short-term rates have risen with each additional Fed rate hike -- while long-term yields have topped out and actually fallen, making it ever more difficult for this kind of business to make money.
When margins are squeezed on what these guys call the "yield spread," so are profits, and this is my concern with NEW. If the yield curve doesn't right itself (and soon) I firmly believe that NEW won't be able to earn its dividend -- and in our land of double-digit returns that kind of development is a big negative and a big no-no. Let's do the prudent thing here and raise cash from this name. The stock went ex-dividend today, so we will get paid the $1.85 third-quarter payment on Oct. 31.
I have a fresh name to rotate this capital into and you'll read about it when the October issue of the 25% Cash Machine hits your e-mail box early next week. My new pick is a much more conservative play in the financial sector, yet still pays a current dividend yield of 11.5%, with 70% of its portfolio hedged against any potential losses.
Stay tuned.
These recommended changes are part of being in a dynamic portfolio. I thought natural gas prices would hold, at least at $5 per Mcf, but that's not happening. I do believe gas prices will recover eventually and we have the opportunity to increase our energy weighting in crude oil -- that's at a steep discount to where it was just trading -- so I feel it is the prudent strategy at this time. I also thought the yield curve would be steeper and not, as it has turned out, flat as a pancake.
That said, we have adjusted our portfolio accordingly and as I said earlier, this is not a static portfolio, but rather it's a dynamic portfolio that requires rotating assets to where they are best served.
See You Friday With the Weekly Update
Bryan Perry
Editor The 25% Cash Machine