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Introduction - Why "Flip the Switch" On Electrical Utilities Now?

Which way is the market headed? Up? Down? Sideways? It's impossible to be sure, especially in the heavily government-influenced economy we find ourselves in today. Everyday there's dozens of new debates on television or articles online claiming the market is going to do this or that. Amidst all this uncertainty, there's at least one thing - okay, two things - I know to be certain:

  1. Larger cap utility stocks provide stable returns and income over the long run
  2. Electricity is a product that people will use forever

It would behoove every investor to devote some portion of their portfolio to this generally safe sector of stocks. These are not "home run" stocks that you can look to for breakout growth and "multi-bagger" returns. They are also stocks that are not going anywhere. They provide a service that everyone needs and uses on a daily basis, hence they are typically low-beta, stable dividend-payers that can offer protection during market downturns. How much of your portfolio, and the factors that help decide how much, is another topic for debate that's addressed in plenty of other financial articles.

In this article, I'll demonstrate a process which any investor can use to find quality, undervalued, dividend-paying and dividend-raising stocks - in particular in the utility sector. I'll take you from the starting point (making the decision to invest) to the finish line (final purchase of one company) in an easy to follow format. I'll show how I came up with a few of my favorite picks in the electrical utility sector - companies that will add long-term value and income to any portfolio, especially at today's deflated prices. I've been working in the electrical/power industry the past 5 years with the U.S. Army Corps of Engineers. During that time I've traveled the world working hand-in-hand with people from some of the best companies in the industry. While this article contains points that would be valid for any utility stock, the electrical industry is one that is specifically near and dear to me, and as such my focus will be geared to that.

Utility stocks have been hated on this year - they are one of the lowest performing sectors of a market that is at all time highs. The following chart shows a comparison of the S&P 500 versus two top utility industry ETFs:

(Source: Yahoo! Finance)
(Click to enlarge)

Notice that the utility industry has returned less than half of the broader S&P index. This may soon change, however, as the market appears to be shifting gears as of late. If the slide continues, utility stock prices will likely increase as people look to shift their portfolios to more stable investments. Thus, now is exactly the time to shift some of your holdings to one of the companies I'll point out in this article, as the share prices are near their multi-year lows.

Sorting Through The Different Companies - The Screen

To begin my search, I used my online broker's (Etrade) stock screener. Any screening program will work similarly. I focused on the "Utility" sector then the "Electrical Utility" industry, which brought me to 148 total stocks. If I wanted to own shares of multiple companies in the industry, it would be much easier to just invest in a popular utility sector ETF such as (NYSEARCA:XLU) or (NYSEARCA:VPU) - two of my favorites due to their low expense, low beta, and decent yield. Many ETFs such as these even trade commission free, another plus. But I'm trying to find a select few safe, undervalued companies that I think can offer a better return than a broader index, so I still had to narrow down the results and weed out the "bad apples" of the bunch. The goal is to end up with about 3-6 companies to evaluate further. To do this, I used the following screening metrics:

  • Forward P/E below industry average - Result: 104 stocks
  • Price/sales below industry average - Result: 72 stocks
  • Price/book below industry average - Result: 48 stocks
  • Profit margin above industry average - Result: 33 stocks
  • Return on equity "ROE" above industry average - Result: 22 stocks
  • Payout ratio below industry average - Result: 12 stocks
  • Positive dividend growth (previous 5 years) - Result: 7 stocks
  • Market cap > $10 Billion - Result: 6 stocks
  • U.S. Companies (Non-ADR) - Result: 5 stocks

The Results Are In

The five remaining stocks from my above screen are:

  1. Consolidated Edison, Inc. (NYSE:ED)
  2. DTE Energy Co. (NYSE:DTE)
  3. Edison International (NYSE:EIX)
  4. Entergy Corporation (NYSE:ETR)
  5. Xcel Energy, Inc. (NYSE:XEL)

As you can see, with minimal effort I've narrowed down what was once a large list of possible choices to 5 similar companies - a much more manageable field of choices to evaluate further. Investors can modify these screening metrics to suit their personal investment style; I tend to use the above examples to suit mine. I believe they aid in identifying companies that are undervalued to their peers. The market cap requirement adds safety and the non-ADR requirement is for tax purposes. Foreign tax requirements can wreak havoc on income portfolios, something that's just easier for me to avoid altogether.

Evaluating The Results - Comparison Of Fundamentals

One could just stop the search right there and select any combination of the remaining 5 similar companies to invest in - this would save time and effort. Many of my peers seem to do this. They come up with a small pool of choices and proceed to just throw a dart at them and buy the stock it hits. However, I find this lazy, rash and irresponsible - my money is too important to me to just leave up to dumb luck. Also, 5 is still too many stocks for me to consider investing in, especially when you add buy/sell commissions into the equation (see prior ETF comment). So how does one decide which company is more likely to reward them with better future returns? Now comes the real work. To further narrow down this field to 1 or 2 choices, I like to do a thorough comparison of fundamentals. I also scrutinize the company's recent news, earnings reports, earnings calls transcripts, and their own future expectations as well as that of analysts. Some examples of how I do this follow.

Here's a table to help get you started comparing fundamentals (data as of market close 12/3/2013):

(Sources: Reuters Global, Yahoo! Finance)
(Click to enlarge)

Whoa. That's a lot of data to digest. Remember, no one said picking stocks would be easy. Also, every investor - and every investment - is different. Each has their own favorite way of comparing and analyzing companies. You must consider your own style to determine which data to place the most importance on - value, growth, income, etc. For the purposes of this article I've tried to sample data pertinent to helping choose the company that's best suited to paying and increasing dividends over the long run. So while analyzing current data as in the table above is a good starting point, it helps to also take into account future projections.

Here's a table comparing expectations and analyst ratings: (Sources: Zacks, Yahoo Finance!)

(Sources: Zacks, Yahoo! Finance)
(Click to enlarge)

Whoa again. That's even more data to digest. Don't get intimidated, it's important stuff and worth the time and effort. After a thorough look at both tables, I see a clear leader emerging from the back.

A Clear Leader Emerges From The Pack

Based on the comparisons of both fundamental data and analyst projections, I like Edison International - EIX as the best pick out of the five companies. Despite being the lowest yielding choice of the 5, I believe it will be the better performer over the long run and thus the best choice for income/dividend geared investors, for the following reasons:

  1. Better margins
  2. Better return on equity
  3. Lower debt/assets
  4. Lowest P/E
  5. Lower Price/cash flow
  6. Lowest payout ratio
  7. Most consecutive earnings beats
  8. Highest earnings beat percentage

It appears that analysts and fund managers like EIX as well, as noted by the following:

  1. Higher institutional ownership
  2. Lower short interest
  3. Highest ABR
  4. Highest number of covering analysts
  5. Highest percent upside to Average Target Price

Edison International has also been one of the better past performers of the group, second only to DTE over the past 2 years, returning around 27% on the share price alone (not including dividends). Included for comparison is the Dow Jones Utility Index "^DJU" on which many of the utility ETFs are based. Note EIX is the black line in the chart below:

(Source: Zacks)


(Click to enlarge)

Timing The Buy - Comparison of Technicals

Ok, so now I've come to the point where I've made the decision as to which company I'll be buying. The next decision, in my opinion, is also of importance - when is the right time to buy? It's one that many novice investors overlook. Sure, in the scheme of things the timing of a buy is not equally as important as the choice of stock to buy, but it is one to consider if you want to maximize your return. After all, we're talking about utility stocks for a dividend/income portfolio. These are not stocks that we're looking at trading frequently; these are "buy and hold" stocks to be held for the long term with the intent of getting paid dividends that hopefully increase over time and can be reinvested or cashed out for income. But eventually the time will come when shares are sold, and hopefully by timing the original purchase correctly, that too will yield a return for the investor.

Every investor has their own preference here as well, but to aid in my timing of a purchase I like to look for a few indicators, including:

  • Share price is within 10% of demonstrated lower support level - larger cap, dividend paying stocks tend to display similar up and down patterns over a period of years. It's best to time your buys during the down periods. Here's a chart of the share prices of X, Y, and Z for the past 2 years (notice the peaks and valleys):

(Source: Google Finance)
(Click to enlarge)

  • RSI under 30 for at least a week (oversold indicator), as indicated by the stock chart and also noted here and here.
  • Recent analyst upgrades (past 30 days). For EIX, some of these can be found here.

Conclusion

If you're looking to add some "power" to your portfolio, electrical utility stocks currently offer an attractive entry point and favorable safety net against a future market downturn. They offer higher yields than the average stock in the S&P 500, as well as a lower beta. This means they are regarded as safer, long-term investments during times of uncertainty. Fundamentally and technically, shares of companies like Edison International compare favorably among the different stocks in the industry. Now looks as good a time as any to go long on a stock like EIX.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in EIX, VPU over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Finding The Right Electrical Utility To 'Power' Your Income Portfolio