Sunday, March 13

Week 245 - S&P 500 Utilities

Situation: Utilities are still getting upbeat press notices for bond-like stability that comes with almost twice the yield, and steady dividend growth. Investors want to invest in these stocks for a variety of reasons but are told they’ll go down in value as the Federal Reserve raises interest rates. These are slow-growth stocks that have to compete with bonds. When new bonds start paying higher interest, legacy bonds (and utility stocks) fall in price so that their yields can rise. But there are other considerations that will help these stocks rebound quickly.
   1) Utilities pay the lowest interest on their bonds because those are backed by a state government. 
   2) The state regulating authority will make sure consumers are charged enough for the utility to realize a 9-11% ROE (Return On Equity), which is necessary to maintain cash flow for maintenance and expansion.
   3) A utility’s dividend payments are a relatively small expense, not as great as its capital expenditures, energy purchases, and labor costs.
   4) Energy is getting a lot cheaper, i.e., coal, natural gas, wind, and solar power are all falling in cost per kilowatt-hour generated. 
   5) Labor costs continue to fall because of automation (software upgrades), and the closure of coal-fired power plants.
   6) Because of “green technology” we are moving to an era of networked sensors (the internet of things), more efficient lighting and wiring, better insulation, and the automated regulation of lighting, heating, ventilation, and air conditioning. In other words, Return on Invested Capital (ROIC) will continue improving through technology, whether or not interest rates rise.

Mission: Let’s take a look at how utility stocks in the S&P 500 Index are doing, now that the Federal Reserve has started raising rates. We’ll set up a spreadsheet that focuses on our quality criteria.

Execution: Start with companies that have revenues large enough to appear on the 2015 Barron’s 500 List, and those that have at least 16 yrs of trading data which allow the company’s weekly stock prices to be analyzed by the BMW Method. We eliminate any company having a S&P Bond Rating lower than BBB+ or an S&P Stock Rating lower than B+/M. Finally, we’ll run Warren Buffett’s method for arriving at Durable Competitive Advantage or DCA (see The Warren Buffett Stock Portfolio by Mary Buffett and David Clark, Scribner, New York, 2011). First we calculate the ratio of stock price divided by Tangible Book Value (TBV). Then we note how many years in the past decade TBV has fallen and calculate DCA, which is the rate of TBV growth over the past decade. 

Administration: We’ve come up with 9 companies. Some generate electricity, others distribute natural gas. But now that natural gas is replacing coal as the main feedstock at power plants, electric utilities are going into the gas utility business. Why? Because they want a guaranteed source of natural gas at the lowest possible price, an in-house supply. The latest example is Southern Company’s acquisition of AGL Resources. Others are building large solar and wind farms. Several have nuclear power plants, and Southern Company is building more. You get the point. Energy is the main feedstock for an electric utility; the company is most efficient if it owns its source of energy.

Bottom Line: Utility stocks make great investments for retirees. You don’t need to back them up with bonds because they’re already bond-like. You can easily make the retiree’s 4% annual withdrawal rate because they have dividend payouts close to 4%; many of those in the 3% range have dividend growth rates of 3-5%/yr, i.e., your utility stocks are yielding more than 4% within a few years of purchase. Spend the dividends and never sell the shares. If you don’t want to go to the trouble of picking stocks, just invest in the benchmark: Utilities Select Sector SPDR exchange-traded fund (XLU) at Line 15 in the Table.

Risk Rating: 4

Full Disclosure: I dollar-average monthly into NEE.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark. Total Returns in Column C of the Table date to 9/1/2000 because that marks the peak of the S&P 500 Index before the “” recession. There have been two peaks since, in 2007 and 2015, so we’re entering the third market cycle since 2000.

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