Every investor has their own individual and specific financial goals, investment strategies, investment risk tolerance, and portfolio construction. The convergence of the first three factors creates the fourth, and without a realistically accurate and in-depth understanding of the first three, the fourth will not be implemented properly. Each of the above concepts should be described in 2 sentences or less - with run-on, compound sentence structure being totally acceptable. What follows would be my best stab at the above.
My specific financial goals: As a full-time retiree with no desire for the trappings of full-time "employment" but with current earned income supplementing my meager social security check, I rely on my investments for the bulk of my living expenses, which are currently a fraction of their lofty past. My overriding financial goal is to create a steady flow of income from a diversified allocation of investments and to create the opportunity for the overall portfolio to enjoy capital gains potential within a 3-yr investing time horizon from the time of purchase.
My investment strategy: As a life-long "value" investor (vs. growth investor), my strategy is to uncover investments whose current valuation offers above-average total return opportunities within this 3-yr horizon, and to reduce the risk of "bad" market timing, the investment position is built in stages, aka "nibbling". It is perfectly acceptable, and even encouraged, to "trade" around a core position, over-weighting when specific market valuations are favorable and under-weighting when they are not, while non-core holdings are purchased, held, and potentially sold with a specific total return targeted.
My risk tolerance: Based on my age and financial goals, I should be risk averse, but I retain a diminutive yearning to relive my adolescent thrill for highflyers. Within the "standard" definition of risk tolerance and according to the worksheets I used for my client's initial meeting, my overall risk tolerance is between "Moderate" (Modern Portfolio Theory Allocation 60% equities/40% bond and cash) and "Moderately Aggressive" (70%/30%), but due to the inescapable fact I am getting older with each passing year, my risk tolerance may soon be leaning more towards "Moderately Conservative" (50%/50%).
My portfolio construction: I utilize four basic investment allocation groups: 1) Cash and an 18-month ladder of CDs; 2) Date-Specific Corporate Bond ETFs and "baby" bonds; 3) Equities Bought Primarily for Income; and 4) Equities Bought Primarily for Capital Gains. Within each of these groups, the strategy is to own a diversified list of assets.
Currently, my total portfolio is allocated as:
- Cash and an 18-month ladder of CDs: 14% of total value with a 1.7% yield
- Date-Specific Corporate Bond ETFs and "baby" bonds: 16% of total value with a 3.3% yield
- Equities Bought Primarily for Income: 34% of total value with a 7.3% yield
- Equities Bought Primarily for Capital Gains: 36% of total value with a 1.5% yield
Other overall portfolio considerations include the belief that a 5.0% 30-yr Treasury yield is the lowest acceptable rate for purchase, and until that time, managing duration and interest rate risk is paramount. Most all investment selections are tracked against a projected total annual return. I have traditionally focused on value investing with smaller capitalization leanings, and this shows up on the Stock Style boxes offered at Morningstar. The current total equity portfolio is classified as 59% Value (16% large-cap, 29% mid-cap, 14% small-cap), 27% Core (9% large-cap, 11% mid-cap, 7% small-cap), and 14% Growth (7% large-cap, 4% mid-cap, 2% small-cap). Overall, large-cap equities comprise 32% of the equity portfolio while mid-cap and small-cap make up 44% and 24%, respectively.
While some positions and selections offer a bit more capital appreciation potential than others, it would seem appropriate for the utility sector to fall within my grouping of Equities Bought Primarily for Income. This group also includes REITs, energy infrastructure MLPs, miscellaneous MLPs, and a few high-yield common stocks. The 12 utilities I currently own comprise 44% of the value of my grouping Equities Bought Primarily for Income and generate 29% of the grouping's income. These 12 stocks combined are 21% of the total equity portfolio and 15% of total portfolio value. In other words, these 12 stocks are an important part of my portfolio construction and its strategy.
The 12 utility stocks are: AltaGas (OTCPK:ATGFF), Dominion Energy (D), Emera (OTCPK:EMRAF), Algonquin Power (AQN), Entergy (ETR), National Fuel Gas (NFG), CenterPoint (CNP), Southwest Gas (SWX), Scana (SCG), Southern (SO), FirstEnergy (FE), and NextEra (NEE).
AltaGas (16% of utility allocation, 8.4% of grouping income, and 5.5% of total portfolio income) is a Canadian-based natural gas utility, or LDC, and midstream company in the final flight-path to acquiring Washington DC-based gas utility WGL Holdings (WGL). As a Canadian company, dividends are subject to a 15% Canadian Dividend Tax if shares are held outside an IRA and are subject to the influences of the Cdn$:US$ exchange rate. Morningstar Quantitative Rating 3 Stars; SPGMI Equity Quality Rank NR. Currently pays 8.6% yield monthly, with a 2-yr total annual return potential of ~11%.
Dominion Energy (15% of utility allocation, 4.7% of grouping income, 3.1% of total portfolio income) is a Mid-Atlantic multi-industry utility. Dominion investors are struggling with two issues weighing on share prices: the proposed Scana acquisition and the sticky predicament of its drop-down MLP, Dominion Midstream (DM), and specifically its desire to transfer ownership of the recently completed Cove Point LNG export terminal. Morningstar Rating 5 Stars; SPGMI Equity Quality Rank B. Currently pays 5.3% yield quarterly, with a 2-yr total annual return potential of ~14 to ~19%.
Emera (9% of utility allocation, 3.2% of grouping income, 2.1% of total portfolio income) is a Canadian-based electric utility with two main operating segments: Nova Scotia Power and Tampa Electric. As a Canadian company, dividends are subject to a 15% Canadian Dividend Tax if held outside an IRA and are subject to the influences of the Cdn$:US$ exchange rate. The combination of an expanding Canadian power generating footprint and a Florida-based utility should offer stable long-term earnings. Morningstar Quantitative Rating 4 Stars; SPGMI Equity Quality Rank A-. Currently pays 5.7% yield quarterly, with a 2-yr total annual return potential of ~10%.
Algonquin Power (9% of utility allocation, 2.9% of grouping income, 1.9% of total portfolio income) is a Canadian-based multi-industry utility with water, natural gas and electric operating segments. As an industry consolidator, Algonquin has a history of acquiring smaller US regulated utilities across multiple industries and building Canadian renewable power facilities. Dividends are subject to a 15% Canadian Dividend Tax if held outside an IRA, but dividends are paid in USD so there are no currency issues. Share prices, however, do have exposure to exchange rate differentials. Recent investments in renewable power in Europe have caused some investor angst, and shares have been weak since the announcement a few months ago. Morningstar Quantitative Rating 3 Stars; SPGMI Equity Quality Rank NR. Currently pays 5.3% yield quarterly, with a 2-yr total annual return potential of ~6% to ~9%.
Entergy (8% of utility allocation, 2.1 of grouping income, 1.4% of total portfolio income) is a Louisiana-based electric utility servicing the Mississippi Delta states and East Texas and operates one of the largest power generating and transmission networks in the sector. Morningstar Rating 3 Stars; SPGMI Equity Quality Rank B. Currently pays 4.6% yield quarterly, with a 2-yr total annual return potential of ~8%.
National Fuel Gas (8% of utility allocation, 1.6% of grouping income, 1.0% of total portfolio income) is a Buffalo-based local natural gas utility with strong exposure to natural gas production in the Marcellus shale where it owns over 780,000 acres. 45% of 2017 earnings were from upstream activities, 38% from midstream and 17% of downstream. Due to its large E&P footprint, some may question the "utility" classification. Morningstar Rating 3 Stars; SPGMI Equity Quality Rank B-. Currently pays 3.2% yield quarterly, with a 2-yr total annual return potential of ~4% to ~13%.
CenterPoint (7% of utility allocation, 1.4% of grouping income, 0.9% of total portfolio income) is a Houston-based natural gas and electric distribution utility that is in the process of acquiring Vectren (NYSE:VVC), and with the new service area, CenterPoint will cover 8 states. The firm also owns 54% of its drop-down gathering and processing MLP servicing the Stack/Scoop area. Morningstar Rating 3 Stars; SPGMI Equity Quality Rank B. Currently pays 4.4% yield quarterly, with a 2-yr total annual return potential of ~10% to ~13%.
Southwest Gas (7% of utility allocation, 1.1% of grouping income, 0.7% of total portfolio income) is an Arizona-based natural gas distribution company with a growing utility infrastructure construction business. Morningstar Quantitative Rating 3 Stars; SPGMI Equity Quality Rank A-. Currently pays 2.8% yield quarterly, with a 2-yr total annual return potential of ~7% to ~9%.
Scana (7% of utility allocation, 0.0% of grouping income, 0.0% of total portfolio income) is a very controversial South Carolina electric and natural gas utility in the political and financial battle of its life. After canceling a partially competed nuclear power plant, Scana became embroiled in a heated political debate on the canceled nukes' cost reimbursement, and acting as a white knight, Dominion Energy has offered to take over the utility, but on its terms. The dividend has been suspended and regulatory movement on a potential acquisition won't happen until after the November mid-term elections. Those who believe Dominion will eventually acquire Scana also believe the final merger could provide substantial capital gains potential. Even with a currently depressed Dominion share price, the acquisition offer is worth $44 per Scana share ($66 per Dominion share x 0.667 offer) or ~22%. If the Dominion share price is pushed up to its $78 to $84 target, the current price of SCG could provide a 45% to 50% gain. Morningstar Rating 5 Stars; SPGMI Equity Quality Rank A-.
It is important for investors to realize controversial stock selections based on specific political events and outcomes, on the outcome of specific legal actions and lawsuits, and on the outcome of a merger proposal add another layer of risk to the equation.
Southern Company (6% of utility allocation, 1.8% of grouping income, 1.2% of total portfolio income) is a multi-industry electric and natural gas utility with a strong presence in the Southern US. Once a stalwart of the utility sector due to its friendly regulatory environment and underlying economic growth profile, Southern has become embroiled in two costly power generation projects - Kemper "clean coal" and Vogtle nuclear plant expansion. Over time, these issues will be resolved without permanent damage to the firm, but over the next few years, more negative headlines should be expected, keeping a lid on share price appreciation. Morningstar Rating 4 Stars; SPGMI Equity Quality Rank A-. Currently pays 5.6% yield quarterly, with a 2-yr total annual return potential of ~14%.
FirstEnergy (4% of utility allocation, 1.1% of grouping income, 0.7% of total portfolio income) is an eastern-Midwest and Mid-Atlantic electric utility in the process of restructuring its business away from a dependency on unprofitable merchant power. FirstEnergy's new strengths will be regulated distribution and more profitable transmission networks. The merchant power business recently filed for bankruptcy and management took on large activist investors as a new source of needed capital. Morningstar Rating 4 Stars; SPGMI Equity Quality Rank B. Currently pays 4.3% yield quarterly, with a 2-yr total annual return potential of ~14%.
NextEra (4% of utility allocation, 0.7% of grouping income, 0.4% of total portfolio income) is a Florida-based electric utility. Florida is a friendly regulatory environment and has been for over 10 years and has a strong underlying population and economic growth profile. Add these to the utility offering substantially lower utility rates than both the national average and other Florida utilities without sacrificing investor returns, and NextEra should be considered a core utility holding. Morningstar Rating 3 Stars; SPGMI Equity Quality Rank A. Currently pays 2.8% yield quarterly, with a 2-yr total annual return potential of ~7%.
Authors Note: Total return is based on achieving Morningstar's Fair Value price target within 2 years. In some instances, M* FV is augmented with either Thomson Reuters Broker Consensus or my own target price, and in which case total return is offered as a range. FirstEnergy and NextEra are new additions to the portfolio and represent starter positions, and it is expected these positions will increase over time.
The most obvious determinants for the prospects of utility companies that are regulated by the government are the actions of those regulators combined with the underlying economic growth in the states serviced. Of these two factors, appreciating the regulatory environment is the more difficult. However, the credit agencies believe this aspect of a utility's business directly affects their ability to repay outstanding loans, and regulatory environments are important to assess. And assess they have.
From 2008 to 2014, S&P Credit published a map outlining its "Assessment of Regulatory Climate for US Investor-Owned Utilities". States were effectively categorized into four groups, and Not Rated as to the credit agency's belief if regulators are "Credit Supportive". The map is shown below and implies that utilities in the states colored blue and green could have improved regulatory relationships.
In 2014, S&P revamped its Assessments and changed the classifications effectively from four groups to three. Within the new scheme, the vast majority of states now fall within the middle category of Strong/Adequate. Investors may take note of the states listed on the left.
Moody's offers a slightly different spin on individual state's utility regulatory environment. In the report from May 2017 titled "Change Is Afoot in Utility Regulation, But Credit Impact Varies", Moody's offers a map with the changes in regulatory credit support it believes are taking place to at least one utility within the state.
As the combination of service territory, regulatory environment, and underlying economic growth drives the prospects for regulated utilities, these factors should be included in utility due diligence reviews.
Overall, regulated allowed ROE has been on the decline and mirrors the decline in interest rate costs for utilities. The trade group Edison Electric Institute offers a historic view of the average quarterly approved allowed ROE going back to 1990 and the 10-yr Treasury Yield going back to 1980. Its charts are below:
Readers should note that the 10-yr Treasury in 1990 (to match the time frame of the Allowed ROE chart) was around 8%.
Over the next many quarters and years, as more "normal" interest rates become prevalent, utility investors should expect regulated allowed ROE to rise as well. Investors should appreciate the historical average regulatory lag time from rate request filing to regulatory approval is 10 months. While the process is even longer from actual cash outlay to inclusion in the rate base and reimbursement, higher interest expense in a rising rate environment will eventually be included in future rate decisions.
I hope this deep dive into my utility portfolio aids some investors in improving how they see their utility holdings.
Author's Note: Please review the obligatory disclosures and caveats on my profile page.
Disclosure: I am/we are long ATGFF, D, EMRAF, AQN, ETR, NFG, CNP, SWX, SCG, SO, FE, NEE, DM. 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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.