Friday, March 13, 2009

The Small-Cap Sector You’d Never Think to Look At

There are very few things we need in this world. According to most state legislatures, heat and electricity are two of these things. If you are planning on moving into a new apartment or house in most states, you are required ― by law ― to have your gas and electricity turned on before you can spend your first night.

Of course, this may seem like common sense. But it does make a statement about the necessities in life. Most areas these days are heated with natural gas… Meaning, you are mandated to pay for natural gas to live.

Here's a small-cap technique to use this pay-to-play mandate in your favor…

Green Energy's Beneficial Impact on Natural Gas

Natural gas is much cleaner than other fossil fuels. Coal and oil are just about as dirty as it gets. For the same amount of energy when burned, natural gas produces 29% less carbon dioxide than petroleum and 44% less than coal.

But natural gas is an important energy type even if it's not simply burned. And it doesn't take much of an imagination to see how more "green" legislation is on the way.

In 2007, Congress worked its way through a bill mandating a ridiculous amount of ethanol to be produced by 2022 ― 36 billion gallons. That's roughly five times more ethanol than is currently produced. And it takes a lot of natural gas to produce that ethanol.

In the U.S., corn is the largest source of ethanol. To grow corn, it takes a lot of fertilizer ― about 22 million tons of fertilizer is consumed every year. The price of fertilizer is 90% dependent on the price of natural gas. On top of that, ethanol plants are powered by natural gas.

While natural gas is greener than what we currently use, there is still one more reason for the natural gas price hike: demand.

If you take a look at the accompanying chart, you can see the expected growth of natural gas in electricity generation. Coal is still the No. 1 energy source, but natural gas is about to blow away oil, nuclear and renewable energies.

The demand for natural gas is only going to strengthen the industry. One way to play this growth is to buy a natural gas producer. However, figuring out which ones will pop is guesswork at best.

What we have today is not a growth story. It's a true profit story. You see, as strong as natural gas is, we aren't going to be placing any bets on future prices. Instead, we found the one segment of the natural gas industry that thrives when the price of natural gas is both up and down…utilities.

Gas utilities perform well no matter what the price of natural gas is. These companies pass on costs straight to consumers.

It's smart business for these distributors. They simply profit from their services, not what the speculative prices are.

Fortunately for us, the overall utility market is fragmented. I know that doesn't sound like a good thing, but it is…

If we had a national utility, we'd end up with a megacap stock that would have too much attention. With attention comes slow to no gains. That's why you won't see us recommend any blue chips here at Penny Sleuth. But, a fragmented industry, such as this one, leads to many small caps to choose from ― many of which are extremely undervalued.

The second important aspect to consider when looking at utilities is the monopolistic attributes these companies have. To get into this business, you have to front a lot of costs. You have to secure the product ― in this case, natural gas ― make sure there's a large enough customer base, and work out the policy issues ― which can be quite a hassle depending on the state and municipality.

You don't normally have a choice of which supplier you want to get your natural gas from. You just get it from whichever utility company is supplying the rest of the community. That gives almost all of these businesses an advantage. It is also the reward for the upfront costs.

On top of that, many of these companies are considered Master Limited Partnerships, which give them another market advantage ― they are tax-free.

With the many small-cap utilities to choose from, it's important to do your research. It takes plenty of digging to find the right one.

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