April 21, 2008

It's seems pretty safe to utter the "R" word. But investors still need to be cautious about where they place their bets. For their part, utilities have weathered the downturn and performed comparatively well.

Utilities have long been known for generating stable revenues and paying predictable dividends. It's a heritage that has paid off in the current economic environment. It's almost entirely a function of the fact that electricity is an essential commodity that must always be purchased. Regulated utilities, meantime, are able to pass through their reasonable expenses that include fuel adjustments while unregulated ones are taking advantage of current higher fuel costs and expected greater demand.

Indeed, utilities have recently outperformed two key indices, the Standard & Poor's 500 and the Dow Jones utility average by nice margins. But the continued rise in utility share values also leads to higher price-to-earnings ratios that make those stocks more expensive than in the past. Those ratios are usually a third less in the utility sector than they are for average companies in the S&P 500. Now, though, they are less slightly less.

The run-up can be attributed to a few things. For starters, utilities had overreached in the 1990s by getting into businesses not germane to their core enterprises as well as by building too much generation. As a result, they took on too much debt. So, when a weak economy slashed the demand for power in 2001, many unregulated ones had trouble. To strengthen their balance sheets, they had to shed debt.

They then focused on their bread and butter operations. That dedication in combination with a low-interest rate environment helped them firm up. Low interest rates have not only decreased their cost of capital but they have also made utility dividends look good when compared to other investments such as Treasury bills.

At some point -- perhaps as early as mid-year or early 2009 -- the economy will turn around. The housing glut will dissipate while the series of Federal Reserve interest rate cuts will take hold. The demand for energy will pick up and give a further boost to utility earnings. Long-term, meanwhile, capacity shortages are expected and will make utility investments more appealing. During boom times, however, many investors will move away from safer instruments offered by utilities and into more aggressive stocks so that they can take advantage of growth.

Positive Outlook

If power utilities are to win investors, they have to pay handsome dividends that yield in excess of what could be achieved in money markets and bond funds. Utilities have been able to deliver because of the constant demand for their commodity -- a product that not only is projected to become increasingly desirable but which will also continue to rise in price as underlying fuel costs go up. That's a benefit to unregulated generation units.

Like the broader market, investors have a choice as to whether they buy shares in individual companies or in a portfolio of stocks. While there is greater upside potential as it relates to the former, there are also more risks. A single entity may get an adverse regulatory ruling that might affect future rates or planned build-outs. Some utilities, for instance, are having trouble winning the necessary permits to build coal plants.

That type of hazard, however, can be mitigated by investing in so-called exchange traded funds. They typically purchase a collection of stocks issued by companies that are in the same industry. While the inherent hedge preserves the downside, those dynamics also limit the upside. MFS Utilities Fund is one such vehicle that is doing well and has experienced double-digit annual gains for the last five years. Other utility stock experts acknowledge Utilities Select Sector that includes investments in Exelon and Southern Co.

In a story that appeared on Microsoft's money network, a utility analyst for MFS says that the fund focuses on established power companies that are allowed by regulators to earn guaranteed returns. It points to Northeast Utilities, which has won approval to spend billions on new transmission lines that should bring a 13.4 percent return on equity.

The fund also likes companies that are building generation in places where energy shortages are projected. As such, it likes Reliant Energy because it has extensive investments in vital infrastructure. Others call out names such as Constellation, Con Ed, Dominion, Entergy, FPL and PSEG. In each case, the holding company controls unregulated businesses that can take advantage of selling an essential commodity at higher market prices.

To be sure, utilities know pain. They didn't just endure hard times in the 1990s. They also did so twice in the previous two decades. In each instance, though, they have recovered by slimming debt and getting back to basics. Today, they shine relative to other sectors and moreover, the overall outlook is positive.

"The fundamentals in this group are about as good as I've seen them," says Claude Davis, analyst for MFS, in the Microsoft money story. "The short-term view, the people who are jumping in today, is that we're going into recession, and utilities outperform in a recession. But others invest because the fundamental outlook remains very solid."

In hard times, utilities are attractive places to invest because they are conservative and provide steady dividends. In good times, they may hum along but investors are often pulled to those industries with more promise. Having learned the hard way, utilities know to focus on the generation and delivery of power -- a philosophy that should keep them on sound footing for the foreseeable future.

More information is available from Energy Central:

• Wall Street Darlings: Hot Stocks Poised for Growth, EnergyBiz, Nov/Dec 2005
• Utilities Dress up for Wall Street, EnergyBiz, May/June 2007