Sunday, February 1

Week 187 - Barron’s 500 List: Utilities With Good Credit

Situation: Utility stocks work a lot like bonds, since most utilities are ~60% capitalized with bonds backed by a state government. Being monopolies, both consumers and investors are protected by state and federal regulation. The Dow Jones Utility Average (DJUA) consists of 15 stocks that have been selected by a committee chaired by the managing editor of The Wall Street Journal. Since 1928, the DJUA has served as a technical indicator for stock-market health. This is due to the fact that stocks (particularly utilities) perform best in a low interest-rate environment. In the 72 yrs since the DJUA bottomed in 1942 (just before the Battle of Midway), it has risen at a rate of 5.7%/yr (without reinvestment of dividends) vs. 7.9%/yr for the S&P 500 Index without reinvestment of dividends, compared to 5.6%/yr for 10-yr Treasury Notes with reinvestment of interest payments.

Since January of '04, an exchange-traded fund that tracks the DJUA (IDU in the Table) has been available. With dividends reinvested, it has grown 2%/yr faster over the past 11 yrs than the lowest-cost S&P 500 Index fund with dividends reinvested (VFINX in the Table). And, it accomplished this feat with lower risk (see Column D and Column I in the Table). However, part of that performance is unsustainable because the Federal Reserve has kept overnight interest rates (for interbank loans) below 0.2% since November of '08. That policy is projected to end in 6 months and, once it does, utility stocks will gradually return to normal valuations relative to operating earnings. But utility stocks will always be somewhat like bonds in that they’ll represent “portfolio insurance” against stock market crashes.

For this week’s Table, we’ve examined all of the utility stocks in Barron’s 500 List of the largest companies by revenue that are listed on the New York or Toronto stock exchanges. The Barron’s 500 List is helpful because companies are ranked both by their combined scores on sales growth and cash-flow based Return On Invested Capital (ROIC). For the Table, we have excluded any companies with an S&P bond rating less than BBB+ or an S&P stock rating of less than B+/M, leaving us with 9 stocks. Six are dividend achievers (Col P in the Table) and 5 are in the DJUA (Col T in the Table). Four are on both lists (NEE, ED, SO, D). A good way to get started investing in utilities is to pick two of those 4 stocks, then use dollar-cost averaging to build a “utility position” that eventually amounts to 4% of your retirement portfolio. There is probably no better investment to have in a low interest-rate environment. In a market crash, they’ll serve you almost as well as a corporate bond fund like the Vanguard Intermediate-term Corporate Bond Index Fund (VFICX at Line 15 in the Table). And a crash can’t be that far off, given the inflation in financial assets since '08 when the Federal Reserve began its policy of Financial Repression. For further explanation of Financial Repression, see Week 76 and Week 79.

Caveat Emptor: Utility stocks are presently over-priced. In the Table, this is seen most clearly for the utilities involved in natural gas storage and distribution (SRE and D): see the metrics for P/E (Col J) and EV/EBITDA (Col K). When running the Buffett Buy Analysis (see Week 30) in Cols U through Y, we see that those same companies have lost much of their future value to investors (see Col Y) because of overvaluation (see Col J and Col K).

The utility industry is evolving. It has been my good fortune to serve on the Board of Directors of a private power company for the past 15 yrs that provides heat, electricity, and air conditioning to an urban institution. The changes have been remarkable, as we’ve gone from depending on a coal-fired power-plant that only employed natural gas for “peaking power” to a natural gas-fired cogeneration plant, supplemented by solar, wind, and hydroelectric power. This is the future, happening now.

Bottom Line: High-quality utility stocks are safe and effective investments to include in your retirement portfolio. As a group, the 9 listed in our Table have returned ~12%/yr since '03 while losing less than 20% during the 18-month Lehman Panic. The index fund that reflects the Dow Jones Utility Average (IDU) did almost as well, gaining ~10%/yr while losing 35% during the Lehman Panic. This record beats the lowest-cost S&P 500 Index fund (VFINX), which only gained ~8%/yr while losing over 46% during the Lehman Panic. The rewards from owning utility stocks outweigh the risks, even in times of financial crisis. The question is: How much longer will the current low interest-rate environment (that has been so beneficial to debt-laden utility companies) persist? I would say we’re closer to the end than the beginning 6 yrs ago. Once interest rates start rising, you’ll see prices hold up better in utilities that have adopted a low “carbon footprint.” Likely beneficiaries include Dominion Resources (D) because of its dominant position major in natural gas storage & distribution, and NextEra Energy (NEE) because of its dominant position in wind and solar power.

Risk Rating: 4

Full Disclosure: I dollar-average into NEE and also own shares of D.

NOTE: metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance vs. our key benchmark (VBINX).

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