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Many investors think about utility stocks and say, “Why bother? Just hand me those high beta stocks, I need my speculative capital gains fix.” Investing in utility stocks, however, accomplishes several important portfolio investment strategies.
As one of the ten S&P industrial sectors, utility companies represent a vital segment of the economy that is somewhat cyclical in nature, while providing investors stability of earnings and dividend income. For a truly diversified portfolio, some utility exposure is expected.
Utilities are generally considered defensive and conservative investments. For example, the S&P Utility ETF XLU has a 5-yr beta of 0.58. Utility investing is usually characterized as slow and steady, where investor patience creates increasing cash returns on initial investment capital along with capital gains.
Every portfolio, regardless of size, should maintain exposure to income-specific investments. Based on the explicit goals of the portfolio, these may include taxable and tax-free bonds, energy MLPs, REITs and utility stocks. While some investors focus mainly on capital gains, total stock return incorporating income and gains is a better measure of investment returns. Investment selections for income can incorporate as much or as little risk as the investor is seeking. Having a steady stream of income available for reinvestment adds to an investors capital base, or can be used for personal needs.
Dividend income is a significant part of the total return when investing in utilities. Dividends are usually of average yield with an expectation of 4% to 6% annual dividend growth over time or are of a higher comparable yield with the expectation of little or no growth. Reinvestment of either flavor of dividends effectively compounds the returns of income growth or higher current yield.
Within the sector, there are several different industries: diversified utilities, natural gas utilities, electric utilities, water utilities. Many utilities will utilize a regulated monopoly business plan where rates and profits are controlled by state and municipal governments. There are segments of the sector where prices are unregulated, such as merchant electric power generation. Merchant companies have greater risk exposure to demand and to commodity market pricing for electricity, but offset the risk with hopefully better growth prospects. Utilities come in all market capitalization from Southern Company (NYSE:SO) at a market cap of $35 billion to Gas Natural (NYSEMKT:EGAS) with a market cap of $87 million.
The current state of business for specific utilities run the gauntlet from stable cash flow generation such as SO, to roll-up acquisitions such as EGAS, to an anticipation of a turn-around in depressed auction market pricing currently affecting merchant producers such as Exelon (NYSE:EXC) market cap $28.5 billion, to potential acquisition candidates such as El Paso Electric (NYSE:EE) market cap $1.2 billion. There are international companies either expanding their presence in the US such as Canadian-based renewable energy utility Algonquin (OTCQB:AQUNF) with a market cap of $675 million or growing in their home markets such as Chile-based Enersis (NYSE:ENI) with a market cap of $12.2 billion.
Without a doubt, for many years the utility sector has been undergoing a dramatic consolidation. This trend will continue for the foreseeable future. Mario Gabelli comments on this trend, along with others, in the 2010 Annual Report of his utility fund (GABUX):

For several decades, utility companies have acquired other utilities and utility assets for the sake of gaining economies of scale and efficiency or divested non-core utility assets to focus on core competencies. Despite over 90 completed utility mergers/acquisitions since 1993, the electric and gas utility sector remains fragmented, with over 60 electric utilities and 30 gas utilities. This is 50 more than we need from the standpoint of economic efficiency.

The balkanized structure of the industry is inherently inefficient, and competitive forces combined with constant changes in regulatory policy pressure marginal players. The big companies feel the need to be bigger to achieve scale economies or gain a strategic benefit, while the small companies are selling out as the cost of staying in the game rises. It is only because of a complex and lengthy merger review and approval process that the industry remains as fragmented as it currently is.

Our investments in regulated companies have primarily, though not exclusively, focused on fundamentally sound, reasonably priced mid cap and small cap utilities that are likely acquisition targets for large utilities seeking increased bulk.

We also like the beneficiaries of developing trends. This has led to our ongoing focus on nuclear power utilities and utilities with material wind development pipelines as a way to benefit from the need for more power from carbon free generation. We favor utilities with pending transmission line developments and also focus on natural gas pipelines and storage operators as a way to take advantage of the growing demand for natural gas in the U.S.

It is easy to create a portfolio of a few utility companies that covers a spectrum of opportunities. The seven companies listed above, Southern Co, Gas Natural, Exelon, El Paso Electric, Algonquin, Enersis and Gabelli Utility Fund certainly could qualify as a diversified utility strategy covering several different trends in utilities and energy.
Southern Co (SO) - beta 0.33, yield 4.5%, payout ratio 77%, anticipated long-term EPS growth rate 6%, 5-yr dividend growth rate 4.1%, 5-yr average return on invested capital (RIOC) 6.2%;
Gas Natural (EGAS) - beta 0.23, yield 5.1%, payout ratio 65%, anticipated long-term EPS growth rate 7%, 5-yr dividend growth rate N/A, 1-yr return on invested capital (RIOC) 6.9%;
Exelon (EXC) - beta 0.61, yield 4.9%, payout ratio 52%, anticipated long-term EPS growth rate 3%, 5-yr dividend growth rate 5.5%, 5-yr average return on invested capital (RIOC) 11.8%;
El Paso Electric (EE) - beta 0.65, yield 2.6%, payout ratio 35%, anticipated long-term EPS growth rate 6%, 5-yr dividend growth rate N/A, 5-yr average return on invested capital (RIOC) 5.4%;

Algonquin (OTCQB:AQUNF) - beta 1.15, yield 4.9%, payout ratio 84%, anticipated long-term EPS growth rate 11%, 5-yr dividend growth rate N/A, 5-yr average return on invested capital (RIOC) 2.2%;
Enersis (ENI) - beta 0.51, yield 4.1%, payout ratio 37%, anticipated long-term EPS growth rate 4%, 5-yr dividend growth rate 4.0%, 5-yr average return on invested capital (RIOC) 7.9%;
Gabelli Utility Fund - beta 0.84, yield 13.7% including return of capital, no dividend growth rate, “4 Stars” Morningstar Rating, $2.3 bil AUM,
The utility sector can offer intriguing opportunities no matter the overall portfolio objective. The next time you think about the stodgy image of utility investing and are tempted to move on, think again. There is a lot going on in the utility sector.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: I am long EGAS, EXC, OTCQB:AQUNF. I'm also long GABUX
Source: 7 Utility Stocks Offering A Spectrum Of Opportunities