The Next Big Thing - Again

By James Brumley | May 31, 2011 AAA

All too often, by the time a trend is big enough and proven enough for the media outlets to tell investors about it, the best part of the move is over. In some cases, a burst of media attention can even be the kiss of death for a rally, as an influx of new amateur buyers allows all those previous institutional buyers to unload their shares without driving the price lower.

The solution? Look for budding trends that nobody is talking about yet. Right now, that's the independent power producers ... names like Constellation Energy Group (NYSE:CEG), The AES Corp. (NYSE:AES), and yes, the now-defunct Enron.

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By the Numbers

The attraction to these stocks isn't a great track record of recent results - quite the opposite, in fact. This group somehow skipped the bulk of the 2010 market rally, with the S&P 1500 Independent Power Producer Index losing about 19% that calendar year, while the S&P 500 gained about 11%. Some of that ground has been made up in the meantime, but the independent power producer index is still well below 2007's peak levels (56% below it, to be precise), while the S&P 500 is just 15% away from getting back to its 2007 peak.

It's the most recent strength, coupled with all that room to recover, that's hinting the group's time has finally come.

When the broad market finally started to fade in late February, the power producers were just starting to shine. The former is a hair underwater since then, while the latter is higher by about 9% and still rolling.

While the relative performance numbers alone paint a compelling picture, it's still not the whole story... stocks can not survive on momentum alone.

Not All Built the Same

As is the case with many industry trends, some of the independent power stocks are doing more work than others, and some of the underlying companies are doing better than others. So, we can take the group-wide bullish clue at face value. We just need to carve out the leaders.

One of them is the previously-mentioned AES. The stock saw a great 2009 thanks to a record-breaking EPS of $1.15 that year. When earnings slumped to 94 cents per share in 2010 - the lowest since 2005 - a soft patch for the stock was understandable. Earnings are on the mend again, though, with $1.07 per share expected for 2011. So far, the stock's been reflecting that growth revival.

A handful of other higher-profile names have started to perk up as well, in terms of earnings as well as their stock's performance. One of the most attractive picks is an off-the-radar small cap, though - Calgary-based TransAlta Corp. (NYSE:TAC). The forward-looking P/E ratio of 17.7 isn't stellar, but after topping estimates in its past two quarters (especially against a backdrop of two earnings misses before that), investors can make a decent case that TransAlta has turned an important corner. (To learn more, see P/E Ratio: What Is It?)

Canada's National Election Helped Outlook

The long-term outlook for TransAlta, in fact, may have improved considerably a month ago when Canada held its national election.

Though the New Democratic Party (or NDP) didn't take a majority control of the country's legislative seats, it bumped its presence up from 34 to 102. It's a big deal to investors, because the NDP's desired energy policy leans heavily toward a carbon cap-and-trade and carbon-tax system. With a major focus on eco-friendly energy sources like wind and geothermal, TransAlta may be able to circumvent much of that potential burden if Canada's New Democratic Party continues its trend and eventually takes a majority of seats in a subsequent election.

On the flipside are noteworthy liabilities like Dynegy (NYSE:DYN), which has not only managed to continue losing money since 2009, but has found a way to widen those losses... with no end in sight.

Bottom Line

As the numbers suggest, the group as a whole is looking healthier, but it's still an individual stock-picking situation. (For related reading, see Five Minute Investing: Stock Picking.) One thing investors may want to consider about what separates the winners from the losers is the reason Dynegy is struggling right now - debt.

Though lower power prices were cited by the company as a problem and cause of last quarter's declining revenue, it doesn't appear to be an issue for other independent power companies. Perhaps the bigger challenge to profit growth for the group's struggling stocks is debt.

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