Utilities Worth Another Look
Utility stocks may be best known for their defensive qualities. But since 2003, they have outperformed the market on the way up as well as on the way down.
The S&P 1500 Utility Sector Index rose 103% from the start of 2003 until the market peaked Oct. 9, 2007, versus a 77% gain for the broader index. And from the peak to the low on March 9, 2009, the utility index fell 45%, while the broader index dropped 57%.
All industry groups within the utility sector have shared in the bounty, as shown in the chart below. All four of the utility industry indexes are up at least 46% during that period.
However, many utility stocks have missed out on the latest recovery. The S&P 1500 Index has jumped 19% this year, versus a 2% gain for the utility index. Not surprisingly, the performance gap has been even wider in the rally from March lows. Since the S&P 1500’s March 9 low, the index has jumped 58%, far better than the utility sector index’s 30% rise.
Utilities make up just 4% of the market capitalization of the S&P 1500. Investors should cap their exposure to this sector at 15% to 20%, and most are probably better off with a significantly lower weighting. If you wish to own utilities, the Top 15 Utilities portfolio (presented on page 5) offers an appealing alternative to betting on one or two utility stocks.
Electric utilities make up 51% of the market value of the S&P 1500 Utilities Index, followed by diversified utilities at 32%. At the opposite end of the spectrum, water utilities represent just 1% of the sector’s market value. While regulated electric utilities still account for the biggest chunk of the sector’s revenue, other businesses have become more important in recent years. Many utilities also generate and market power or produce natural gas and oil.
Regulated operations account for about 65% of the sector’s total revenue. Power generation and marketing account for about three-fourths of the sector’s nonregulated revenue, while electricity distribution represents about three-fourths of regulated revenue.
In recent years, high prices for oil and natural gas have fattened the bottom lines of utilities with nonregulated operations, and not just those that produce energy. When natural gas prices rise, the price of power tends to rise as well.
In late 2008 and 2009, the energy-price exposure that boosted profits in recent years had the opposite effect. Natural-gas prices sank to a seven-year low in August, further pressuring electricity prices already weakened by the recession and a cool summer.
Wall Street expects traditional electric and water utilities to deliver the sector’s best earnings growth next year. Such stocks tend to enjoy steady revenue streams less dependent on energy prices. Quadrix® favors utility/energy hybrids, which average Overall scores of 71, the highest of the utility groups. Hybrids also look attractive as measured by our 12-Factor Sector and Reranked Overall scores, which were designed to rank stocks within a given sector.
Higher natural-gas prices and the increased demand for electricity likely to accompany an economic recovery should boost results at most utilities. The average utility is expected to grow profits 9% in the next fiscal year.
While the utility sector has outperformed the broader index since 2003, investors should not expect outperformance during periods when most stocks are rising. But neither should investors dismiss the sector. Below we present three reasons for optimism about utilities:
• With money rushing into economically sensitive stocks, utilities represent a hedge against a market correction.
• The spread between yields on electric utilities and the S&P 500 yield is near a five-year high, and utility stocks also look attractive relative to yields on 10-year Treasury bonds.
• The average utility in the S&P 1500 Index earns a Quadrix Overall score of 65, the highest level since July 2001 and well above the average of 53 since 1994. Over the last year, utilities’ operating momentum has looked more attractive relative to that of other sectors.Investors seeking both defensive ballast and a solid dividend yield should consider investing a portion of their assets in our equal-weighted Top 15 Utilities portfolio. This diversified group of utilities offers a 3.9% yield, close to that of the average utility, with substantially higher total-return potential. So far this year, the Top 15 Utilities portfolio is up 8.1%, versus 1.9% for the S&P 1500 Utilities Sector Index. This week, we are replacing two stocks in the portfolio.
Regulated gas and electric utilities account for more than 90% of Avista’s ($20; AVA) revenue. Consensus estimates project profit growth of 15% this year and 11% in 2010. Despite that superior growth potential, Avista trades at 13.6 times trailing earnings, 29% below its five-year average P/E.
Targeting a payout ratio between 60% and 70% of earnings, Avista has grown its dividend at an annualized rate of 12% over the last four years. The current dividend represents 56% of trailing earnings. Given Avista’s profit-growth potential in coming years, more dividend hikes are likely. Avista, which is being upgraded to an A rating in the Utility Update, is being added to the Top 15 Utilities portfolio.
Exelon ($51; EXC), with electric utilities in Illinois and Pennsylvania, is the largest nuclear-power generator in the United States. Sales are about evenly split between the company’s two principal operations: electric utilities and power generation and marketing. Exelon’s hedging program has helped insulate the company against the weak power market, though the company does have some exposure to power prices. Natural-gas prices should rise over the next year, which in turn should help support higher power prices.
Wall Street expects per-share-profits to fall 2% this year and another 1.5% in 2010. With the worst of the economic weakness likely behind us and power prices likely to rise next year, Exelon should be able to top those modest expectations. Exelon, yielding 4.1%, earns an A rating in our Utility Update and is being added to the Top 15 Utilities portfolio.
Allegheny Energy ($27; AYE) has boosted its sales in each of the past five years, growing at an annualized rate of 5% during that period. However, the profit story, especially recently, is far less cheerful. Per-share earnings have declined 43% over the last four quarters. And with consensus estimates trending lower, we’ve lost confidence in Allegheny’s outlook. Allegheny is being downgraded to a B rating in the Utility Update and dropped from the Top 15 Utilities portfolio.
Alliant Energy ($28; LNT), an electric utility, has grown revenue in each of the past four years. However, profits have been less predictable. Sales growth turned negative in the last two quarters, and per-share profits have fallen in each of the last five quarters. The utility also trimmed 2009 profit guidance in August, triggering a sharp reduction in the consensus. Wall Street’s 2010 profit-growth target of 15% may prove too optimistic. Alliant is being downgraded to a B rating in the Utility Update and dropped from the Top 15 Utilities portfolio.