Know what you are getting
Forecasts readers love utility stocks.
We hear from enough of you to say that with confidence. And you’re not the only ones with a passion for power companies.
About 75% of the total stock-market value of the S&P 1500 Index is owned by institutional investors, mutual funds, and company insiders. That leaves only about 25% of shares in the hands of individual investors, also called retail investors.
However, the utility sector is about 38%-owned by retail investors, as shown in the chart below. No other sector has as large a portion of its stock-market value in the hands of individual investors.
Investors like utilities for two main reasons:
High yields: Utility stocks in the S&P 1500 Index average a yield of 3.7% — highest among the 10 sectors in the index.
Low volatility: Historically, the utility sector has been less volatile than most sectors. However, that stability has come with a price — below-average returns, as the chart below illustrates. Since the end of 1994, the S&P 1500 Utilities Sector Index has returned 105% including dividends, less than half of the broader index’s 241% return and second-worst among all sector indexes.
While the appeal of utility stocks is obvious, investors must understand what they are buying. In the following paragraphs we present four facts every utility investor should know:
No free lunch with yield: Utility stocks tend to have high yields, but the sector has underperformed over time. Even within the sector, the highest-yielding stocks have lagged.
More than power companies: The core utility business hasn’t changed much. It requires a lot of capital, generates decent cash flows, and grows slowly. But many utility companies operate businesses other than regulated electric, natural-gas, and water distributors. These stocks face different market forces and may not move in concert with traditional utilities.
Stable doesn’t mean safe: Utility stocks are less risky than most, but they are still stocks. The S&P 1500 Utility Sector Index outperformed the broader S&P 1500 Index over the last year, but has lagged substantially since the end of June. Dividend-paying stocks haven’t done well in recent months, and utilities have taken their share of punishment.
Subpar returns: While most investors probably realize that stocks with the highest potential returns have the highest risk, few seem to consider that low-risk stocks tend to have the lowest potential returns.
Do the warnings above suggest everyone should dump their utilities and load up on technology stocks? Not at all. Utility stocks make sense for many investors. But keep in mind that utilities make up less than 4% of the stock market’s total value. Even income-oriented investors shouldn’t keep too much of their money in utilities. Few portfolios should have more than 20% of their weight in utilities — and for most people, an optimum weighting is far lower.
Regarding the money you do want to invest in utilities, our Top 15 Utilities portfolio can help. As the table on page 5 shows, the Top 15 portfolio is a diversified group of utilities with better-than-average growth potential and a solid yield. Four stocks from the portfolio are reviewed below.
Alliant Energy ($33; NYSE: LNT) provides electricity and natural gas to customers in Wisconsin, Iowa, Minnesota, and Illinois. After its creation in 1998 through the merger of three utilities, Alliant made unsuccessful investments overseas that dragged on earnings, contributing to a 50% dividend cut in 2003. Alliant has since sold most of its nonregulated businesses and increased the annual dividend for five straight years.
Regulated businesses now account for about 95% of revenue. Alliant is expanding in its current territories, planning to spend more than $1 billion a year on power plants. New wind and coal plants should come online over the next five years, increasing generating capacity by more than 20%. Alliant, yielding 4.2%, earns an A rating in our Utility Update and is part of the Top 15 Utilities portfolio.
Because of its diversified business mix, CenterPoint Energy ($14; NYSE: CNP) has the potential for stronger, steadier growth than many peers. In the first half of 2008, net income increased 12%, driven by growth in electricity distribution and natural-gas pipelines. Consensus estimates project per-share-profit growth of 8% in 2008 and 6% in 2009, targets well within reach for CenterPoint.
CenterPoint serves more than 5 million customers, distributing electricity in Houston and natural gas in Texas, Arkansas, Louisiana, Minnesota, Mississippi, and Oklahoma. CenterPoint also sells natural gas on the wholesale market and owns interstate pipelines. The pipeline business is benefiting from increased drilling activity. CenterPoint is spending heavily on new pipelines, a move that should boost earnings over the next several years. The stock yields 5.1%. CenterPoint earns an A rating in our Utility Update and is a component of the Top 15 Utilities portfolio.
MDU Resources ($28; NYSE: MDU) has increased its dividend in each of the last 18 years, including a 7% hike in August. Per-share profits jumped 36% in the first half of the 2008, mostly because of strong performance from the production and pipeline units.
Company operations include natural-gas and electric utilities, natural-gas and oil production, natural-gas pipelines, construction materials, and construction services. Higher energy prices and production increases are driving outstanding results in the production segment. MDU does little hedging of its expected production, which creates upside when prices are high but also exposes the company to declining prices.
Consensus estimates project per-share-profit growth of 31% this year and 6% in 2009. Management said it expects to drive growth through a combination of internal expansion and acquisitions. In July, MDU agreed to acquire Intermountain Gas, a utility that serves about 300,000 customers in a growing area of Idaho, for $328 million. The deal should increase MDU’s utility customer base by nearly 50%. MDU is rated A in our Utility Update and is part of the Top 15 Utilities portfolio.
UGI ($26; NYSE: UGI) operates regulated gas and electric utilities, but also markets propane and wholesale power. The company operates one of the largest distributors of liquefied petroleum gas in France and owns 44% of AmeriGas Partners ($31; NYSE: APU), the largest U.S. retail propane concern. UGI’s utilities serve nearly half a million customers in eastern Pennsylvania.
In March, UGI agreed to buy a natural-gas utility and propane business from PPL ($36; NYSE: PPL) for $268 million. In July, the company announced a $36 million project to generate electricity using landfill methane gas — one of the largest operations of its kind in the U.S. Consensus estimates project per-share-profit growth of 13% in fiscal 2008 ending September and 5% in fiscal 2009. UGI, rated A in our Utility Update, is a component of the Top 15 Utilities portfolio.
Top 15 portfolio adds Allegheny
It’s been a rough year for utility stocks, with the S&P 1500 Utilities Sector Index down 18.7%. Our utilities have suffered as well, but the Top 15 Utilities portfolio is down 9.7%, nine percentage points better than the sector index.
The Forecasts prefers stocks with strong Quadrix scores. Utilities in general earn poor Overall scores because of their modest growth and high debt levels. We developed the Utility Sector Score as a tool for rating the investment appeal of utility stocks relative to other utility stocks.
The Utility Sector Score is volatile, and we don’t like to overreact and downgrade a stock too quickly. But AGL Resources ($33; NYSE: ATG) has seen its Quadrix scores decline steadily over the last three months. The natural-gas utility earns an Overall score of 39 and a sector score of 31. AGL’s sales and profit growth has slowed in recent quarters, and profit margins are on the decline. The shares are no longer cheap relative to other utilities. AGL still has solid long-term growth potential, but given its weak Quadrix scores, we are dropping the stock in favor of a company with a better mix of growth and value.
Allegheny Energy ($38; NYSE: AYE) has delivered per-share-profit growth of at least 21% excluding special items in each of the last five quarters. Allegheny’s regulated utilities serve 1.6 million customers in Pennsylvania, West Virginia, Maryland, and Virginia, and its power-generation unit has excellent growth potential. Consensus estimates project per-share-profit growth of 15% this year and 32% next year. At 16 times estimated 2008 earnings, you can buy that growth for an attractive price. Allegheny is being added to the Top 15 Utilities Portfolio.