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How To Build A Utility Portfolio # 2

|About: Brookfield Infrastructure Partners L.P. (BIP), Includes: BIP, DUK, ENB, FTS, NFG, PSCU, ROIC, SO, WTR, XLU

Within the water utility sub-sector, there is an underlying movement for the small municipal water district to sell out to larger publicly traded water companies. This trend is fueled by budget constraints and the cost to comply with stricter clean water standards, along with the need to upgrade aging water infrastructure. While a slow-growth subsector, water utility earnings are driven by acquisition expansion rather than organic growth, and this trend will continue for the near future.

A great place to find potential utility investments lies in the holdings of selected mutual funds and ETFs. For large-cap utilities, review the holdings of the S&P 500 Utility ETF (NYSEARCA:XLU). For small-cap utilities, review the holdings of the PowerShares Small Cap Utility ETF (NASDAQ:PSCU). As there is no ETF for mid-cap utilities, review this SA article that lists these companies. GABUX also offers an interesting list of utilities (pdf) that Gabelli believes may be part of the continuing consolidation trend. The latest holdings of GABUX, as of Sept 30, 2012, can be found here. TheNew York Times also provides a list of utilities by sector [Multi-line (diversified), Electric, Natural Gas, Water and Others] and can be found here.

As with all capital-intensive sectors, it is very important for investors to understand and review each company's return on invested capital (NASDAQ:ROIC) over the more readily available return on equity (ROE). ROIC incorporates shareholder returns on both total equity and total debt deployed by management. For example, a company with a debt to equity (D/E) ratio of 0.78 and a ROE of 7.5% has actually performed about the same for shareholders as a competitor with a D/E of 1.52 and an ROE of 10.5% as the former has a ROIC of 4.21% while the latter has a ROIC of 4.16%. The easy formula for calculating ROIC is: ROIC=ROE/(1+ (D/E)). offers both trailing 12-month and 5-year averages for ROE and current D/E ratios, and is easy to access under its "Financials" section of stock and company reviews.

It is important for investors to develop a diversified portfolio of utility companies that incorporate different market capitalizations and sub-sectors. For example, an investor could hold the following portfolio of utilities (this is not an exhaustive list, just an example of diversity in a utility portfolio):

  • Southern Company (NYSE:SO) - regulated electric, solid financials, excellent regulatory environment, exposure to southern U.S.;
  • Duke (NYSE:DUK) - regulated electric, above average yield
  • Exelon - regulated electric and merchant power, waiting for a turnaround in auction power market;
  • AES - regulated electrical with merchant power exposure;
  • National Fuel Gas (NYSE:NFG) - regulated natural gas with natural gas exploration;
  • Spectra Energy (NYSE:SE) - natural gas infrastructure;
  • ITC (ITC) - regulated electric transmission;
  • Aqua America (NYSE:WTR) - regulated water;
  • Algonquin Power (AQUNF, AQN.TO) - Canadian alternative energy and US water utility, expanding in the US;
  • Brookfield Infrastructure (NYSE:BIP) - international utility and infrastructure.

As many utility stocks are bumping up against their 52-week highs, and the utility sector as a whole has been strong over the past few years, it is important for investors to choose wisely. Developing a list of prospects with entry points below where they are currently trading may be a cautious and prudent approach.

The investment objective should be to generate double-digit annual total stock returns, but current share price valuations along with current yields may not allow for such a lofty goal.

Author's Note: Please review important disclaimer in author's profile.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.