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Utilities are a corner of the market that I normally avoid, but I believe that the opportunities are too great to ignore. I am no expert in the area, but I have been spending some time learning about some of the big-picture drivers as well as the details about a few of the names. I shared my interest initially in December as I focused on higher-yielding Utilities and have reposted it to my blog. I subsequently made two purchases in February, which I disclose below, but this is really a sector call.

Utilities are generally regulated, though many participate in unregulated activities and some are totally unregulated. The sector is typically low-beta and higher dividend yield than stocks in general. Capital structures tend to be significantly more leveraged than other industries. While one of my goals when I invest is to find good management (or at least be fully aware when management is inferior), it's hard to find stand-outs in the sector. Even when one does identify strong management, other factors dominate the earnings outcomes, like regulatory or even weather. So, for someone who typically likes to invest in companies with strong balance sheets and superior management, I can't be blamed for not spending a lot of time on Utilities.

In the Russell 3000, just 95 companies are classified as Utilities. The S&P GICS system breaks down the sectors into various industries, including pure Electric Utilities, Gas Utilties, Multi-Utilities, Water Utilities and Independent Power Producers. Here are the definitions according to Standard & Poor's:

Electric Utilities

Companies that produce or distribute electricity. Includes both nuclear and non-nuclear facilities.

Gas Utilities

Companies whose main charter is to distribute and transmit natural and manufactured gas. Excludes companies primarily involved in gas exploration or production classified in the Oil & Gas Exploration & Production Sub-Industry. Also excludes diversified midstream natural gas companies classified in the Oil & Gas Storage & Transportation Sub-Industry.

Multi-Utilities

Utility companies with significantly diversified activities in addition to core Electric Utility, Gas Utility and/or Water Utility operations.

Water Utilities

Companies that purchase and redistribute water to the end-consumer. Includes large-scale water treatment systems.

Independent Power Producers & Energy Traders
Companies that operate as Independent Power Producers (IPPs), Gas & Power Marketing & Trading Specialists and/or Integrated Energy Merchants. Excludes electric transmission companies and utility distribution companies classified in the Electric Utilities Sub-Industry.

If you would like to see the entire universe, sorted by industry and then yield: Download Utilities Sorted By Industry on DivYld

Here are some observations that encourage me:

  • Many companies, especially electricity or gas providers, were crushed in 2009 by the plunge in industrial demand, but there should be a recovery in demand.
  • Fears abound about "Cap and Trade" and emissions controls, but those risks seem to be abating and investors forget that some or all of the costs will be passed on.
  • A few high-profile rate cases with negative or less-than-expected outcomes have concerned investors, helping to create an attractive entry.
  • The majority of Utilities yield more than 4%, many more than 5%.
  • It's not difficult to find regulated utilities trading below tangible book value.
  • These stocks went down hard in 2008, barely rallied in 2009 and are down a bit in 2010, meaning that they have underperformed the market.
  • M&A is a strong possibility - note the recent deal (FE for AYE)
  • Everyone knows about the sector, but not very much - it's just 4% of the market, meaning that it could be as mispriced as I suggest.

I believe that Utilities are poised to rally this year by 20% or so as the dividend yields come down. My forecast is dependent upon a slow economy in which we see some growth that allows industrial demand to pick up compared to its implosion last year, but not too much growth. If the economy booms, my call will be horribly wrong. First, other stocks will be a better place to be, as they are more leveraged to earnings growth. Second, and perhaps more significantly, very strong economic growth means higher interest rates, the anathema of yield investors.

The easiest way to play the sector is through an ETF. SPDR Utilities Trust (NYSEARCA:XLU) represents the S&P 500 names only. iShares offers its version (NYSEARCA:IDU), but it is an odd-lot in comparison and tracks XLU extremely closely despite having more names. I have chosen to invest in two electric utilities, Portland General (NYSE:POR) and Allete (NYSE:ALE). POR is Oregon's regulated electricity provider. It has been hit by the the weak industrial demand, but it has its own set of stumbling blocks including warm weather and low hydroelectric availability. The stock was handed out to Enron investors a few years ago as a settlement, so not surprisingly it was dumped, though that is well behind them now. I like the valuation and the yield (5.4%), and the stock trades well below tangible book despite having D/E ratio lower than typical for the industry (<100%). A catalyst that many fail to appreciate is that it could be added to the S&P 400 Mid-Cap index. Allete, which is basically Minnesota P&L, is covered by only 2 analysts as is also outside of the S&P indices. The yield of 5.3% and a Debt to Equity of just 75% make me comfortable waiting for that Midwest Industrial recovery! These may not be the very best ways to play, but I wanted to share what I had done. Both of these names are in the Conservative Growth/Balanced Model Portfolio, which isn't too surprising, but I also put them in the Top 20 Model Portfolio because I think that they can return 20-30% over the next year.

The chart below for the market-weighted composite of S&P 500 Electric Utilities highlights the attractiveness of the group. The equal-weighted numbers are very similar: (Click to enlarge)

Electric Utilities

Note that dividends have grown and continue to grow (albeit slowly), that the dividend yield is well above the median for the past decade and that the yield relative to the 10yr Treasury is still quite higher than normal.

Here is the same set of charts for S&P 500 Utilities overall:

Utilities 030510
It's the same story, but with lower numbers due to lower yields in some of the other sectors. For a final thought, consider how the sector looks relative to another large yield sector, REITs.

Utility vs REIT Yes, the Utilities and REITs are back to their beginning of 2008 price relationship. Yes, the P/B ratio relative to the REITs is well below its traditional relationship and very close to its lows (1.4X vs. 2.0X). Yes, you get more yield in the Utilities (4.50 vs. 3.60). Yes, the PE ratio is at an extreme (11.7 for Utilities, 15.5 for REITs - and sorry, this is not FFO or AFFO. REITs are the expensive yield play that factors in a strong economy. Utilities are the cheap one that doesn't need that at all.

I think that XLU can get to 36 or so based upon the yield dropping to 3.60. That's more than 20% upside before the dividend. To me, the regulated electric utilities look like the real bargains. I think that buying the large-caps works quite well, but there may be some opportunities in smaller names that provide even more upside.

Disclosure: Long ALE and POR

Source: Utilities: An Opportunity Too Great to Ignore