Roger S. Conrad

It’s been roughly seven months since the Dow Jones Utility Average last made a new high. Since then, it’s underperformed the S&P 500 by nearly 21 percentage points. Most blame fear of rising interest rates. I fault the manic expectations that pushed prices to unsustainable heights last year. But whatever the catalysts, sector valuations are returning to earth. What’s remarkable is this is happening despite extremely healthy industry earnings, demonstrated by robust first quarter results. Equally encouraging, regulatory treatment of corporate tax cut savings has so far supported utility balance sheets, as well as rate base and earnings growth, removing a key concern of credit raters. As the Endangered Dividends List shows, not every essential services company is prospering. But high quality companies that have retreated to good entry points increasingly outnumber the stragglers. So far this year, we’ve added Comcast Corp (NSDQ: CMCSA) and Edison International (NYSE: EIX) to the Portfolios at their lowest prices since 2016. This month, we’re picking up Sempra Energy (NYSE: SRE). The other Focus stock is Kinder Morgan Inc (NYSE: KMI), which pulled off a major coup in late May by selling its controversial Trans Mountain pipeline to the Canadian government. Not surprisingly, lower valuations have revived utility sector mergers and acquisitions. My feature article highlights three ways to bet: Arbitrage plays on deals already announced but not yet closed, buying stocks of likely takeover targets and picking up high yield bonds of merger candidates that have much to gain by being acquired.

Successful big pipeline projects move the profit meter in the energy midstream business. But when they go wrong, they can quickly diminish a developer’s growth and financial health. That was the growing risk to Kinder Morgan Inc (NYSE: KMI) before it sold its Trans Mountain pipeline and expansion project to the Canadian government. Now management has CAD6.4 billion in saved capital expenditures as well as CAD4.5 billion in sales proceeds to invest in a wide range of potential projects. And that’s in addition to $12.7 billion of backlog already in development, targeted to produce $1.7 billion of additional EBITDA by 2021.

Sempra Energy (NYSE: SRE) is the latest blue chip utility on our long-term target list to slip back to a buying range. This month, we’re adding the stock to the Conservative Holdings. Sempra’s business strengths are legion. On March 9, the company succeeded where Warren Buffett failed, closing on the former Texas Utilities’ regulated electricity transmission and distribution assets. The deal brought its regulated global utility customer base to over 43 million, including San Diego G&E, Southern California Gas and 6 million users in Chile and Peru.

Everyone wants to buy low and sell high. But in practice many investors do the opposite, particularly with daily stock market trading dominated by exchange traded funds and algorithmic investment strategies. For us, this means opportunity. Specifically, we’re able to buy high quality essential services companies at the lowest valuations in many months.

Enbridge Inc (TSX: ENB, NYSE: ENB) is buying the remaining common units of the two US MLPs it controls: Enbridge Energy Partners (NYSE: EEP) and Spectra Energy Partners (NYSE: SEP). It’s a good deal for the acquirer, which is buying these assets for barely 7 times cash flow. Absorbing the regulated natural gas and oil pipelines should dodge a possible Federal Energy Regulatory Commission-mandated rate cut. And management has affirmed three-year earnings guidance while promising faster growth after 2020.

Mergers and acquisitions have been part of the landscape for as long as utilities and essential services have been around. And remarkably, not one deal has failed to create a stronger company.

If worries about rising interest rates are hitting utility stocks so hard, why are shares of real estate investment trusts (REITs) surging?