Utility stocks that can plug you into yields instead of losses

September 6, 2011

Students, walking to school, are dwarfed by power towers in Pickering east of Toronto December 12, 2000. REUTERS

After trailing the market in 2009 and 2010, utilities have emerged as its leading sector, and a number of analysts believe they are on track to maintain that position for at least the rest of 2011.

The Standard & Poor’s 500 Index fell 3 percent in the first eight months of the year, while utility shares  rose 7.3 percent. In August, the index fell nearly 6 percent, while utilities went up 1.7 percent.

Investors have been drawn to stocks of electric, gas and water utilities for a number of reasons. Dividend yields north of 4 percent look tempting when 10-year Treasury securities yield less than 2.5 percent. The stocks are less volatile than the rest of the market, and their stable earnings and other defensive characteristics stand out in a weak economic environment. The extension of the favorable 15 percent tax rate on dividends through 2012 also adds to their appeal, at least for now.

Fans include Robert W. Baird & Co. utility analyst David Parker, who noted in a recent report that, “If boring is good, and it likely is with growing global economic uncertainties, then the utility sector should not disappoint,” in the second half of 2011. Citing their resilience in a weak economic environment, Standard & Poor’s changed its portfolio allocation recommendation on utilities from “market weight” to “over weight” in late August.

But the appeal could evaporate quickly if the stock market gets bullish again and plodding stability starts looking drab again. That happened in 2009 and 2010, when utility stocks rose 21 percent over the two years, compared to a 51 percent leap for the S&P 500 Index. Rising interest rates, which would prompt income-seeking investors to abandon stocks for higher-yielding bonds, could also end the party fairly quickly.

“In a strong bullish environment, utility stocks won’t do as well as cyclical or growth stocks,” warns Tim Winter, a utility analyst with Gabelli & Co.

But these “flight to safety” investments tend to shine when interest rates are low and economic growth is weak — a scenario supported by the White House’s recent projections for GDP growth this year of 1.7 percent, a downward revision of the 2.7 percent growth it predicted back in February. Winter believes that while the stocks have done well since the beginning of the year, they are still “reasonably priced, if not undervalued” based on his estimates of 2012 earnings and their attractiveness to investors in a slow growth, low interest rate environment.

Those agree, and who would like to add to their holdings in the sector, have a few ways to do it.

Mutual funds
What you won’t get from most utility-focused mutual funds is the highest-possible yield. Because the funds’ annual expenses typically range from 1.25 percent to 1.75 percent of assets, and are subtracted directly from dividend payments, many of the funds yield less than 3 percent.

What you will get from the right utility fund, however, is management that can produce peer-beating total returns with less volatility than the overall market. Two funds that are Lipper Leaders for total return, consistency and preservation of capital fall into that category.

Gabelli Utilities Fund differentiates itself by including many small and mid-cap names. That’s important, says Winter, because such stocks have benefitted from industry consolidation and should continue to do so.

MFS Utilities Fund takes a broad-based approach by including companies with regular revenue streams, such as those in the cable industry, alongside traditional electric and gas utilities. The fund has about one-third of its assets in foreign securities and also owns some industry convertible bonds.

Exchange-Traded Funds
If higher yield from a diversified portfolio is a priority, focus on lower-cost index ETFs. With an expense ratio of .20 percent Select Sector Utilities SPDR (XLU), by far the largest of the group in terms of public trading value, provides an attractive level of income. The large cap portfolio is relatively concentrated, with the top five holdings accounting for over one-third of assets. Another popular offering, Vanguard Utilities ETF (VPU), has many of the same stocks but is more spread out and includes some small and mid-cap names as well. It has a 24 percent expense ratio. Both yield about 4 percent.

Individual stocks
Winter cites El Paso Electric (EE) as a low-risk traditional utility investment with solid earnings growth potential and a strong customer base. One of the fund’s larger utility holdings, electric and gas utility Dominion Resources (D), should benefit from its ability to raise prices and expanded gas distribution capabilities.

MFS Utilities Fund manager Maura Shaughnessy sees the most compelling values right now in European utility stocks, such as the Czech Republic’s CEZ Group and Portugal’s EDP, which trade on their home country exchanges. While the stocks have lagged their U.S. utility counterparts because investors associate them with weak European economies, the companies themselves are financially strong, well managed, and on track to grow earnings.

Robert W. Baird’s David Parker includes Wisconsin Energy Corporation (WEC), Alliant Energy Corporation (LNT), and Xcel Energy (XEL) on his list of stocks he expects to outperform the market in the coming months. He believes all of them should experience 4 to 6 percent annual earnings per share growth and maintain their healthy dividend yields of 4 percent to 5 percent.

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