Choosing The Best Utility Stocks For Growth In Your Portfolio

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Includes: AEP, CEG, EXC, NGG, PPL, XEL
by: Brian Nichols

One of the great securities of investing is utility stocks. They typically trade in tight ranges, with low beta, and have great yields. Most are relatively low risk and return much better year-over-year gains than government issued bonds or interest bearing accounts. Yet because of a historic period of financial hardships over the last five years utility stocks are trading with significantly low valuations, towards the bottom of a 13 year range in the sector's P/E ratio. Therefore some of these utility stocks are presenting great value and may return large gains along with a consistent yield for security. But like most stocks some are better than others and investors should be cautious of which utility stocks they choose to purchase.

When choosing a utility stock you must consider the trends of energy and what political pressures may arise to shift from one to another. In a previous article I covered the benefits of owning Exelon (NYSE:EXC) and I stated that the stock would reverse its trend after announcing earnings on January 23. But after careful consideration and a more detailed comparison between EXC and other utility stocks I no longer believe it's one of the better investments to own, in fact I am not sure I like the investment at all.

Exelon is very large with a market cap of nearly $27 billion and trades at just 11x earnings which is below the average utility stock. The company delivers electricity to 5.4 million customers and 490,000 natural gas customers making it one of the largest and most well-diversified utility companies in the market. The stock's been beaten down over the last 5 years with a 30% loss, however investors believe it's now presenting value and are willing to bet on the company's success because of its yield of 5.17 and an upcoming merger with Constellation Energy (NYSE:CEG) that could be a game changer. Yet despite these facts I still believe there are much better utility investments for your portfolio.

The reasons to like EXC are the same reasons that I am bearish on the company's long-term future. The company does operate in a very large area and has a very balanced and diversified energy portfolio which is encouraging to many investors. However, as an investor the diversity actually causes me to rethink my position because of the recent pessimism towards nuclear power and natural gas continuing to fall in price. The company focuses on clean fuel which means it should be prepared for any and all political pressure towards new energy, which I expect as part of the upcoming presidential race. Energy will be one of the primary topics and contributing factors to who wins the upcoming presidency and I believe that EXC's diversification could actually hurt its chances of growth. The problem with being well diversified is regardless of how good one segment performs you will always have one or maybe two that lag or drive earnings lower.

Most utility companies pay great dividends which result in a perception among investors that each company is equal. However, these companies require the same research and speculation as an investment in a technology or consumer goods stock. Investors are typically hesitant to invest in companies with falling fundamentals so why invest in a utility company with falling fundamentals when there are so many others with improved earnings.

When you are deciding on a particular utility stock for your portfolio make sure you compare the fundamentals. There are many utility stocks that maintain its price despite falling fundamentals because of a high yield. But sooner or later the fundamentals will always affect a stock price therefore I'd rather buy a stock that is fundamentally growing. I have included a chart below of EXC and 4 other stocks that show each companies fundamental growth during the last 12 months compared to 2010. The growth is shown as a percentage which is the percentage of growth year-over-year. Yet if no growth was returned then I listed the amount of money lost during the last 12 months compared to 2010. The debt-to-assets ratio is charted to give investors a better idea of how well positioned a particular company's balance sheet trades.

Company Ticker Revenue Income Debt-to-Assets
Exelon (EXC) 4% ($153 million) 27%
PPL Corp. (NYSE:PPL) 22% 46% 45%
American Electric (NYSE:AEP) 5% 27% 34%
Xcel Energy (NYSE:XEL) 3.5% 10% 34%
National Grid (NYSE:NGG) 53% 55% 50%
Click to enlarge

The chart above compares Exelon with four of the best performing utility companies of 2011. As you can see each of these companies, besides EXC, grew in both revenue and income year-over-year and improved both profit and operating margins. The only category that EXC is outperforming the other four companies is with its debt-to-assets ratio, which is a huge importance to making any investment. It gives you a sense of how strong a company's balance sheet is performing and EXC has a great ratio for a utility company. However, the company's balance sheet may negatively be affected following the merger with it and CEG.

After looking at the fundamental growth of both the top and bottom lines of these five utility companies we have a better understanding of financial growth over the last year. Therefore, we can move on and look at valuations and trading tendencies to better help us find the better value within this sector. Below I have included one final chart that shows the stock information and performance of each of these five companies.

Company Ticker Market Cap (billions) P/E Ratio 1 yr perf. 5 yr perf. yield 5 yr yield gain
Exelon (EXC) $26.98 11.17 (3.4%) (33%) 5.18 20%
PPL Corp. (PPL) $16.38 10.71 7.4% (20%) 4.94 13%
American Electric (AEP) $19.86 12.63 14.5% (2%) 4.57 20%
Xcel Energy (XEL) $13.23 15.90 16% 19% 3.81 18%
National Grid (NGG) $34.50 10.21 11% (30%) 6.18 n/a
Click to enlarge

When deciding on a utility stock for your portfolio you must decide what pieces of data are most important. Because as you can see each stock has its strengths, whether it's a higher yield, faster growth, or better performance. Therefore you must decide what purpose the utility stock serves within your portfolio.

Each of these stocks are relatively large companies but are trading at different levels of valuation. The P/E ratio could be the single most important piece of data for long-term utility investors whose goal is to avoid purchasing a stock at its high point. In my opinion each of these stocks are priced cheap and when you look at the P/E ratio for the sector prior to the recession in 2009 you would see ratios much higher, which should encourage investors that assuming fundamentals are strong none of these stocks are near resistance. Therefore I place little importance on the P/E ratios and believe that with the exception of NGG and PPL each of these stocks are fairly priced compared to fundamental performance along with the current valuation of the sector.

The one and five year performance shows that each of the stocks, with the exception of EXC, traded higher in 2011 with fundamental growth. However, I am once again surprised of PPL and NGG's modest gains considering its strong earnings. This data in conjunction with its fundamentals show that these two stocks may be presenting high value for its current price and that neither stock has appreciated in value. The five year performance is irrelevant because the price-to-earnings ratio of the sector has nearly been cut in half over the last five years. This drop in price does not reflect fundamental weakness but may indicate current value within a stock, and a sector.

Based on this information alone, of fundamental growth over the last year, and each stock's performance I believe that PPL and NGG are presenting the best value for a long-term investment. Both stocks have near flat future P/E ratios which means the market expects earnings to remain consistent. Both PPL and NGG show the highest level of growth while having the lowest valuations along with solid yields. These two stocks, based on previous information, would seemingly make a great long-term investment with the potential to return large gains. Yet because of XEL's consistency, the stock may be a good investment for those who can't afford to endure the volatility that comes with the market.

Overall, I think each of these stocks will rise at some point in the near future and would make good investments. There has been a lot of excitement surrounding EXC and in my opinion it's simply not the best investment within the sector. Utility stocks are long-term holds and because of low P/E ratios, solid growth, and the high volatility of the market I believe that 2012 will be another great year for these stocks and that the utility sector will finish 2012 as one of the best performing sectors within the market.

Disclosure: I am long PPL.