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This part will deal with regulated energy utilities. We have returned to the world of "normal" corporations that pay tax on earnings and whose dividends receive preferential tax treatment in contrast to flow-through entities like REITs and BDCs. For an investor unfamiliar with the world of utility regulation, this sector can be confusing and the application of metrics designed for the Dow 30 to these stocks can be misleading.

First, a little background. This industry is predominantly regulated at the state level and there is significant variation in the scope, content, and execution of state regulatory authority. However, as a general matter, it was decided roughly 100 years ago that certain businesses were "natural monopolies"(we didn't want four sets of electric poles and wires in our neighborhoods) and also required enormous capital expenditures.

For this reason, franchises were awarded giving certain companies monopoly power over their "service territories." As part of the "regulatory bargain," these companies would be subject to regulation of their prices and services. This regulation was generally delegated to a state public service commission. Over the years and after considerable litigation, various principles of regulation began to be accepted.

Companies were to be given the opportunity to earn, but not a guarantee of, a "reasonable return" on their investment in facilities "used and useful" in providing service. That reasonable return was to be calculated so as to permit the company to continue to attract investment dollars for future capital expenditures. A company's ability to pass through its cost to ratepayers was conditioned upon a "prudency" test and, under certain circumstances, imprudent expenses could be disallowed.

It should be immediately obvious that this system established a very different world from the world inhabited by Ford (NYSE:F) or Apple (NASDAQ:AAPL) and so comparison of these stocks with other equities can be very misleading. There began to be pressures on the regulatory contract and, with enormous variation from state to state, competition was tried in the wholesale market and, even to a limited extent in the retail market.

It was generally recognized that local distribution of electricity was a natural monopoly but argued that generation was not. Thus, a number of initiatives led to more competition in the generation market, but this varies considerably from state to state.

The production and generation of electricity tends to be very capital intensive - a nuclear power plant can cost more than $2 billion to build. Construction takes a long time and enormous amounts have to be spent long before power is generated.

As a result, these companies tend to have large investment in plant and equipment. Because of the safety associated with the regulatory contract and at least some monopoly status, these companies are generally viewed as relatively safe and they have been able to borrow large amounts of money to fund plant expansion. Because bond interest rates are generally lower than the rate of return required on equity, regulators often prefer that these companies have a relatively high debt to equity ratio. As a group, these companies tend to have a relatively high debt load. You will not find the net cash rich balance sheets of the high tech industry in this group.

The stocks in this group generally provide more stability but less growth potential than industrial stocks in general. Throughout the Panic of 2008-09, there was never a quarter in which there was a decrease in the dividends paid in aggregate by the stocks in the Dow Jones Utility Index. There was only one quarter in which the dividends did not increase sequentially (they stayed the same). This is an impressive record given the carnage that income investors went through during that period.

It is also the case that these stocks tend to increase dividends slowly but steadily over time and, in that sense, have a big advantage over fixed income investments. On the other hand, you will not get explosive growth with this group. Their activities are, by and large, confined to the United States so that you will not benefit from growth in emerging markets or get a tailwind from a declining dollar. And rising interest rates can be bad for this group by increasing the interest they have to pay on debt and also because they are viewed as "bond-like" investments.

Here are what I consider to be some of the better names. An investor should research the sector closely and diversify because there is always the danger that an individual stock will be adversely affected by a bad regulatory decision or operational difficulties. In each case I have given the symbol, Friday's closing price and the dividend yield.

  1. Consolidated Edison (NYSE:ED): ($52.40), (4.6%)
  2. American Electric Power (NYSE:AEP): ($37.10), (5.0%)
  3. Exelon (NYSE:EXC): ($42.02), (5.0%)
  4. Duke Energy (NYSE:DUK): ($18.51), (5.4%)
  5. Entergy (NYSE:ETR): ($68.17), (4.9%)
  6. Constellation Energy (NYSE:CEG): ($37.14), (2.6%)
  7. Dominion Resources (NYSE:D): ($47.25), (4.2%)
  8. Edison International (NYSE:EIX): ($38.70), (3,3%)
  9. Southern Company (NYSE:SO): ($39.43), (4.8%)
  10. PEPCO (NYSE:POM): ($19.18), (5.6%)

I generally prefer utilities with service territories that have relatively strong economies so that there is some growth, or at least not attrition, in sales volume and there may be less political pressure to shift burdens from ratepayers to utility shareholders. On that basis, ED (NYC), POM (DC), EXC (Chicago and Philly), and D (Virginia) look attractive - especially at these dividend yields.

EIX has a significant competitive power producer which gives it more potential upside but also a degree of potential downside. I generally advise that an investor buy a group of these stocks to minimize the impact of any problems an individual stock may have. I think that an investor in this group will probably outperform most fixed income strategies (especially in a taxable account) over time as dividends slowly but steadily increase.

Source: Desperately Seeking Yield Through Equities: Part 6 - Utility Stocks