Issues

Second-quarter earnings are in for most of the more than 200 essential-service companies in our coverage universe. You can find our analysis of these results in this month’s update to the Utility Report Card. One quarter’s results won’t make or break most companies, but this earnings season was of particular importance for two reasons. By most valuation metrics, utility stocks trade at levels not seen the early 1960s; this earnings season provided a reality check to see if the companies’ underlying fundamentals lived up to the market’s lofty expectations. Growth has also stalled out in some industries and economies this year. The past quarter’s earnings and management teams’ outlooks for the remainder of the year provide an early test of how vulnerable companies could be in a bear market or recession. The vast majority of the names that we cover continue to deliver the goods as businesses, with most meeting or exceeding their guidance. Although some companies earned higher buy targets and we feel more comfortable with some names that had landed in our doghouse, many of the stocks in our Utility Report Card trade at unsustainably high valuations. At these levels, the risk of a pullback remains elevated.

At the midway point of 2016, the utility and telecom sectors have emerged as the top performers in the S&P 500, delivering total returns of more than 20 percent. Given the make-up of our model Portfolios, we’re not complaining. Our Conservative Income Portfolio holdings have rallied an average of about 25 percent this year, while the names on our Top 10 DRIPs list have gained an average of almost 30 percent. The Aggressive Income Portfolio has posted an average total return of about 15 percent, while the spotlighted stocks from each issue have gained an average of 14 percent. Although we remain confident in our holdings’ underlying businesses and growth prospects, stretched valuations suggest that the recent momentum-driven gains won’t last. Historically, the risk of a pullback is elevated whenever the Dow Jones Utilities Average trades at more than 20 times earnings and yields less than 3 percent—a cause for caution. We continue to emphasize the importance of taking advantage of this rally to reduce risk, rebalance your portfolio and take some profits off the table in big winners. This dry powder will come in handy during the inevitable pullback.  

The Dow Jones Utilities Average finished the week at a record high and the index’s price-to-earnings ratio has blown out to levels last seen in early 2008. Although this froth in the market increases the bar of expectations for utility stocks and heightens the risk of a pullback, our favorite utilities enjoy ready access to low-cost capital and ample opportunity to grow their rate base through investments in renewable energy, pipelines and gas-fired power plants. The recent momentum driving utility stocks higher reflects concerns about the US economy and the market’s growing realization that the Federal Reserve will struggle to raise interest rates this year. In this environment, investors gravitate toward utilities’ resilient cash flow and above-average dividend yields. Whereas reliable earnings are enduring features of regulated utilities, the influx of capital driving these stocks to new highs rests on something far more fickle: investor sentiment. When momentum investors find an excuse to take profits off the table, the sector will take a hit, regardless of underlying fundamentals. In this environment, investors should take advantage of the rally to exit riskier names, take some profits off the table in their winners (14 Portfolio holdings trade above our buy targets) and assemble a shopping list of stocks to buy when the inevitable pullback occurs.

We’ve enjoyed the recent rally in equity markets immensely, with our laggards finding their footing and a handful of the names in our Conservative Income Portfolio hitting all-time highs. But stretched valuations increase the risk that results will disappoint the market’s lofty expectations. When investors disregard valuations to pay this much for dividends, the risk of a selloff increases. Meanwhile, first-quarter results from the essential-service companies that we track in our Utility Report Card reveal warning signs that corroborate our concerns about weakness in the US economy. a number of electric and gas utilities reported slumping sales to industrial users. Although utilities generate the preponderance of their cash flow from residential and commercial customers and shouldn’t be troubled by this headwind, weakness in this segment suggests that activity in this part of the economy have continued to slow. Against this backdrop, investors should continue to exercise caution on cyclical businesses and names with excessive leverage. You can also play offense by setting limit orders to buy high-quality utility stocks at dream prices that would only be hit in the event of a significant pullback in the broader market. None of the 214 essential-service companies that we cover announced a dividend cut over the past month. But elevated valuations and potentially slowing growth suggest that investors should consider reaping at least a partial profit on some of the gains earned during the recent rally. Those looking to deploy capital should scrutinize the soil before they sow their seeds.

Morningstar (NSDQ: MORN) recently reported that 247 mutual funds suffered outflows of at least 10 percent over the past year, with 18 losing more than 40 percent of their assets under management. Redemptions on this scale usually occur toward the end of a bear market, when many investors throw in the towel. This hemorrhaging stems from the growing belief that passive investment strategies involving exchange-traded funds (ETF) will outperform an active management over the long haul. Lower fees also help to bolster overall returns. Of course, ETFs and other products that offer one-stop exposure to a particular sector or theme often weight their positions by market capitalization. Utilities Select Sector SPDR (NYSE: XLU), for example, rebalances its holdings quarterly and exhibits a bias toward stocks that have already run up. At last check, NextEra Energy (NYSE: NEE), which trades at a record 21 times trailing earnings, accounted for 9 percent of the ETF’s portfolio. And the instant diversification offered by ETFs mean that you’ll always own the good, the bad and the ugly, which dilutes the best performers’ contribution. But discriminating investors can take advantage of the rise of ETFs.  

Last Week, the US Dept of Energy’s Advanced Research Projects Agency (ARPA-E) held its annual Energy Innovation Summit in Washington, DC. Senate Energy & Natural Resources Committee Chairwoman Lisa Murkowski (R-AK), former Vice President Al Gore and Dept. of Energy Secretary Ernest Moniz got most of the attention. But the real stars were hundreds of new technologies on display with the potential to dramatically enhance the grid’s efficiency, reliability and affordability. Energy utilities will be the ultimate beneficiaries of these advances. Still able to access low-cost capital and armed with regulators’ support, dozens of electric companies have stepped up investment in transmission and distribution systems, as well as renewable energy and storage solutions. These investments boost utilities’ rate base and, by extension, earnings and dividends. Utilities’ biggest growth opportunities come from growing demand for renewable energy and low-cost natural gas—topics that we explored at length in the February issue of Conrad’s Utility Investor. Regulated electric and gas utilities historically have posted annual earnings growth in the low single digits; these trends, coupled with the innovations in energy storage, should enable some of our favorite names to increase their cash flow and dividends at an accelerated rate. All of our Portfolio holdings have reported fourth-quarter results, as have most of the names in our coverage universe. This month’s update to the Utility Report Card has all the details and our latest assessment of more than 200 essential-service companies. We also raised our proprietary Quality Grades on nine stocks and downgraded 11.

Since mid-December 2015, the Dow Jones Utilities Average has rallied more than 12 percent—an impressive performance in what has been a dismal year for US equities. These returns vindicate those of us who resisted the conventional wisdom that rising interest rates spell doom for utility stocks, increasing these companies’ costs of capital and reducing the value of future dividends. But this success brings a new challenge: Many of our favorite utility stocks have rallied above our buy targets. Although these stocks trade at lofty valuations today, weakness in the US economy and deterioration in key technical indicators suggest that equities could suffer further downside in coming months. Keep your powder dry and stay focused. Our favorite utilities boast low costs of debt and equity capital that put them in prime position to accelerate their earnings and dividend growth by investing in renewable energy and gas distribution and transportation. My colleague Elliott Gue has called for utility stocks emerge as the top-performing sector in the S&P 500 this year—I can’t say that I disagree. But investors must remain selective.

For the 39th time since 1969, the Dow Jones Utilities Average rallied in the fourth quarter. But this upside didn’t prevent the benchmark from finishing the year with a 3.1 percent loss, the index’s first negative return after a positive January since 1987. Fortunately, the primary catalyst for the loss—uncertainty about when the Federal Reserve would start raising interest rates—no longer exists. And just like the beginning of the 2004-06 tightening cycle, utility stocks have gained ground despite weakness in the broader market. But last year’s challenges remain in play for 2016. Energy prices have yet to find a bottom. Non-investment grade debt has become crushingly expensive to refinance, tightening capital markets for all but the strongest companies. Emerging markets continue to struggle. And any international currency not pegged to the US dollar find itself under pressure. The Quality Grades for the 214 essential-service companies tracked in our Utility Report Card provide insight into the spectrum of risk and help investors to avoid the riskiest names.

I’m hosting an exclusive online chat for Conrad’s Utility Investor subscribers at 2 p.m. ET Wednesday, Dec. 9. The format is simple: You ask me any questions on your mind; I stay online until all questions are answered. And don’t worry if you can’t stick around for the entirety of this marathon discussion; a transcript of the proceedings will be available the next morning. We’ll discuss macro developments or specific stocks covered in my Utility Report Card—whatever’s on your mind. Given the severe downdraft in oil and gas prices since summer 2014, I expect to receive a lot of questions about our outlook for these commodities and midstream energy names that own pipelines and other infrastructure. The indiscriminate selling of these stocks has propelled yields into the stratosphere, reflecting concerns about volumetric and counterparty risks and questions about these companies’ ability to grow or even sustain their distributions. With the debt and equity markets effectively closed for many energy stocks, funding remaining growth projects will be a challenge. Although master limited partnerships (MLP) and other midstream operators face real challenges, the selloff afflicting these names has engulfed survivors whose growth prospects remain intact. As always, indiscriminate selling creates opportunities for discriminating investors. This month’s feature article highlights my top pick in each of the nine industry groups tracked in my Utility Report Card as well as names that you should avoid at all costs. We also revisit Kinder Morgan (NYSE: KMI) in the light of the company’s recent press release indicating that the firm will reevaluate its dividend policy for next year.  

With 90 percent of the companies in our Utility Report Card having reported quarterly results, five times as many names increased their earnings guidance than those that revised their outlook lower. Our favorite utilities have continued to deliver the goods and look well-positioned to weather any storms, thanks to their limited operational risk, supportive regulators, low costs of capital and exposure to various growth drivers. Despite solid third-quarter results from most utilities, the Dow Jones Utilities Average has given up 3.6 percent of its value in the fourth quarter—usually a period of seasonal strength. Some of this weakness reflects expectations that the Federal Reserve will raise interest rates, eroding the value of utilities’ dividends. Never mind that the Dow Jones Utilities Average outperformed during the Fed’s last tightening cycle or that normalizing monetary policy will occur gradually. With technical indicators suggesting that US equities could slip into a bear market next year, we’ve taken profits on a few big winners and will stick to our tried-and-true strategy of buying high-quality names when they trade at favorable valuations.