It has been a tough few years for income investors as they struggle with the low interest rate environment engineered by the Federal Reserve. One of the beneficiaries of this desperate search for yield has been the utility sector. However, I believe this trend is starting to reverse and utilities are a dangerous place for income investors at current valuations. I think investors are starting to realize this judging from the fact Utilities were the worst performing of the ten S&P Industry sectors during last week's post-election sell-off. Usually utilities perform as a defensive area in turmoil and do better than the overall market in declines. Income investors looking for a new home for their funds should consider energy MLP's focused on the oil & gas area of the market. There are myriad reasons why this area should outperform utilities in the near and medium term.
Dividends: Not only do most energy MLP's provided a higher yield than utility stocks, they are also required to pay out at least 90% of their returns in distributions to their shareholders. This is important as dividend tax rates are set to start increasing significantly in 2013 (maybe up 43% for high income earners depending on the outcome of the fiscal cliff negotiations). Utilities will be tempted to divert some of their cash flow into stock buybacks and other corporate uses rather than increasing dividend payouts as a direct consequence of rising dividend taxes. MLPs have little choice but to distribute profits to investors.
Government policy: The re-election of President Obama ensures the "war on coal" will continue if not escalate. In addition, expansion of nuclear energy is probably dead in the water for the next four years as well. Utilities that have coal or nuclear plants obviously will be negatively impacted, and I would look for a lot of write downs as a result. Oil & Gas MLPs will not be impacted to the same extent. They might have some minor regulatory impacts, but I doubt they will be major. The oil & gas sector has created one out of every five jobs since the recession ended. Moreover, outside of some additional government regulators and bureaucrats, these have been few of the high paying jobs created over the past five years.
Growth: Simply put, there is little to no growth in the Utility sector. It will expand at the rate of electricity demand growth or around 1% to 2% annually. Oil & Gas MLPs should continue to experience rapid growth as new technologies allow the United States to continue its march to energy independence (Just not on public lands).
Valuations: Utility stocks are selling at a historically high premium to the overall market. I would look for that to revert to the mean over the coming year as investors flee the sector for better opportunities. Energy MLPs still seem reasonably priced given their growth prospects. In addition, they seem ripe for the massive amounts of private equity (PE) money that is on the sideline given their prodigious cash flows and solid growth. I would look for PE players to continue to be very active in the space.
Recommendations: Given all this, I think investors will and should continue to gravitate to the energy MLP area. Two of my favorite plays in the sector are Linn Energy (LINE) and Calumet Specialty Products (CLMT). Both yield over 7%, are reasonably priced and have good growth prospects. They have both been kind to my portfolio from a yield and capital appreciation angle since I added them earlier in the year. Click on links for more detail on why they are good income pick ups.