Issues

From June 2004 to June 2006, the US Federal Reserve raised the benchmark interest rate by 425 basis points to 5.25 percent. Over this period, the Dow Jones Utilities Average generated a total return of more than 61 percent. Utility stocks stumbled a bit in the early part of 2004, when speculation swirled that the Fed would raise interest rates. But once the central bank made its move, these stocks recovered swiftly. Bottom Line: During the Fed’s most recent tightening cycle, the Dow Jones Utilities Average posted its second-best two-year return since World War II. Market history is one reason we’re not concerned that rising interest rates will sap our favorite dividend-paying utilities. And the prospect of elevated volatility in the near term creates opportunities, enabling us to add high-quality names to our model Portfolios at favorable entry points. Meanwhile, a combination of attractive valuations, low costs of capital and the never-ending quest for scale has fueled a wave of utility mergers and generated windfall profits for lucky shareholders. This month’s feature article highlights three strategies for investors to profit from the upsurge in mergers and acquisitions in the utility and telecom sectors.  

The bull market for stocks that began in March 2009 continues to charge ahead, while volatility, as measured by options trading, remains near an all-time low. However, some sectors and equity groups find themselves in a painful bear hug. The prospect of further downside from crude-oil prices has extended the energy sector’s mauling after a brief recovery rally earlier this year. And the Alerian MLP Infrastructure Index, a capitalization-weighted index of 25 traditional master limited partnerships, has given up almost 40 percent of its value over the past 12 months. Up until a few weeks ago, investors couldn’t get enough exposure to renewable energy, especially rapidly growing yieldcos. But these niche securities have sold off precipitously, with the Bloomberg North American Power Yieldco Index tumbling more than 20 percent since the end of May. Meanwhile, a rampant US dollar has eroded the value of American investors’ international equities and their dividends, though this headwind has abated of late. Amid all these challenges, the Dow Jones Utilities Average has perked up after a difficult spring, rallying 8 percent from its low in late June. Some of these inflows could come from money rotating out of dividend-paying energy stocks, a repeat performance of a trend that emerged when oil prices collapsed in fall 2014. Although the Dow Jones Utilities Average remains well off its high in late January, valuations look reasonable and a period of seasonal strength is just around the corner. More important, earnings have lived up to management teams’ guidance from the beginning of the year. Of the companies covered in our Utility Report Card, 20 revised their guidance higher when they reported quarterly results and 141 maintained their outlook.

The bull market’s seventh year is off to a less-than-rousing start for income investors, with the Alerian MLP Index down 11.5 percent and the Dow Jones Utilities Average down 6.5 percent. Even shares of American Water Works (NYSE: AWK), the largest US water utility, have given up 4.7 percent of their value in 2015. Meanwhile, the S&P 500 has gained only 0.7 percent this year. In our coverage universe, the S&P Telecommunication Services Index has emerged as the big winner, eking out a 2.3 percent total return. This weakness in US equities reflects an uncertain macroeconomic environment that’s clouded by China’s slowing growth and the Greek sovereign-debt crisis. A muddy outlook for US economic growth hasn’t helped matters. Speculation about when and to what extent the Federal Reserve will raise interest rates has heightened volatility in the stock market. Meanwhile, oil prices appear poised for another downdraft, now that we’ve passed the peak of the summer driving season. Over the past six years, best-in-class utility stocks have followed market corrections with big-time gains. We expect more of the same once the market settles down, especially if our favorites post solid second-quarter results. Nevertheless, investors have ample cause for caution. The Dow Jones Utilities Average’s performance this year bears an eerie resemblance to 1987, the last time the sector faltered badly after a winning January. And another breakdown in oil prices, an interest rate hike and/or more weakness in China could roil equity markets further. My midyear strategy balances a long-term focus on quality and value with short-term opportunism: By cashing out of outperformers with limited upside, we can stockpile some dry powder to deploy in a correction. We’ve sold about half a dozen Portfolio holdings since mid-2014, booking sizable gains on most. This month, we’re liquidating our position in Conservative Income Portfolio holding ONE Gas (NYSE: OGS) for a 38.1 percent profit. Although the gas utility boasts a solid dividend, the stock trades at 21 times earnings—a lofty valuation that doesn’t reflect emerging questions about future growth.

On June 9, I’ll host an exclusive live chat for Conrad’s Utility Investor subscribers. We’ll start at 2:00 p.m., and I won’t sign off until I’ve answered every question. A transcript of the event will be available the next day. Given the recent uptick in Treasury yields and scuttlebutt about the Federal Reserve hiking interest rates, we’ll probably spend a fair amount of time discussing the best strategies for the current environment. When you look at the historical data, the Dow Jones Utilities Average exhibits scant correlation to movements in interest rates. In fact, utility stocks have posted gains in years when interest rates have climbed and when they’ve fallen. Nevertheless, the conventional wisdom persists that dividend-paying stocks will get walloped because rising interest rates erode the value of future dividends. This faulty logic treats stocks like bonds and overlooks the potential for dividend growth.

The price of West Texas Intermediate crude oil has rebounded roughly 40 percent from its mid-March low. Meanwhile, natural gas fetches about half what it did a year ago. And natural-gas prices are even lower in Pennsylvania, where surging production from the Marcellus Shale has overwhelmed local demand and existing takeaway capacity. Depressed natural-gas prices weigh heavily on the spot price of wholesale electricity, putting pressure on power companies that don’t sell their output under long-term agreements or face impending contract expirations. Smaller telecom providers have also suffered margin compression in an increasingly saturated and competitive market. Throw in economic troubles in Brazil and other international markets, and you’ve got a lot of headwinds facing the more than 200 essential-services companies covered in our Utility Report Card. Nevertheless, of the 193 companies that have reported results thus far, only four disappointed to such an extent that management trimmed their full-year guidance for revenue or earnings. Of course, these ranks will grow over the course of the year, as management teams rethink their projections. Businesses with the most exposure to commodity prices face the most risk. Still, the resilience demonstrated by the companies in our coverage universe represents a big part of the appeal of investing in essential-services companies. And after more than a decade of reducing debt and de-risking operations, the utility sector finds itself in its best shape ever.

Erratic economic growth and sinking energy prices have made investment in solar power an unexpected upside catalyst for US electric utilities’ earnings growth. Two days after closing the sale of its remaining gas- and coal-fired merchant plants, Duke Energy Corp (NYSE: DUK) announced plans to install 500 megawatts of solar power in Florida. This announcement followed on the heels of Duke Energy investing $225 million in REC Solar Commercial Corp—a deal that made the North Carolina-based utility an instant player in distributed electricity. The company also plans to roll out 720 megawatts of solar-power capacity in the Carolinas. Dominion Resources (NYSE: D) owns almost 25 gigawatts of nuclear and thermal power plants and operates more than 33,000 of natural gas pipelines. The utility has 400 megawatts of solar-power capacity under development in Virginia and another 744 megawatts across seven other states. Meanwhile, Sempra Energy (NYSE: SRE) and Southern Company (NYSE: SO) reportedly have contemplated forming yieldcos to finance their renewable-energy plans. NextEra Energy (NYSE: NEE), the nation’s leading producer of wind and solar energy, demonstrated the appeal of this structure with the market’s reception of NextEra Energy Partners LP (NYSE: NEP). For the same investment, utility-scale solar-power plants produce more than four times the electricity output by residential rooftop systems and twice as much as commercial distributed generation. Utilities’ existing customer relationships also give them a huge leg up in marketing rooftop solar-power systems. These realities put money-losing SolarCity Corp (NSDQ: SCTY), Vivint Solar (NYSE: VSLR) and other would-be usurpers at a huge competitive disadvantage. But the growth opportunity in solar power is great news for a utility sector contending with slackening electricity demand and pushback on rate increases. Read more about these risks and opportunities in my Special Report, Renewable Energy: How to Make Green and Avoid Red.

The lowest US unemployment rate in seven years has sparked speculation that the Federal Reserve will raise interest rates sooner than expected, giving traders a convenient excuse to sell dividend-paying stocks. Arguments can be made for and against the Fed raising interest rates. On one hand, the federal funds rate continues to hover near zero, and the central bank has long cited 5.5 percent unemployment as a prerequisite for gradually normalizing monetary policy after a period of extraordinary accommodations. On the other hand, inflationary pressure remains negligible. Hiking interest rates would also propel the Uncle Buck even higher, undermining the nascent revival of US manufacturing and the finances of many developing-world economies. Misjudging which course of action the Federal Reserve will take won’t ruin your portfolio. However, rashly selling your dividend-paying stocks doesn’t make a lot of sense; future returns for utility stocks, master limited partnerships and telecom stocks won’t depend on the US central bank’s next move.

Momentum-seeking money, which last year helped the utility sector to outperform, has shifted to dividend-paying energy stocks and telecoms since Jan. 28, 2015, when the popular Utilities Select Sector SPDR (NYSE: XLU) hit its all-time high. In subsequent weeks, the exchange-traded fund has given up more than 7 percent of its value; on the opposite end of the teeter-totter, the S&P 500 Telecommunication Services Index has rallied by roughly the same amount and the Alerian MLP Index has climbed 4.6 percent. These moves represent a reversal of the trend that held sway from the end of September to the end of January, when the S&P 500’s telecom stocks gave up 7 percent of their value and the Alerian MLP Index dropped by more than 17 percent. Over the same period, Utilities Select SPDR generated a total return of almost 20 percent. Don’t panic over this latest shift in momentum. This pullback gives savvy investors an opportunity to buy some our favorite utility stocks at more reasonable prices, though a good chunk still trade above our buy targets.

The Dow Jones Utilities Average returned 30.7 percent in 2014—the index’s best showing since 2000. Telecoms, energy and most international stocks posted far less impressive results. Our Conservative Income Portfolio and Aggressive Income Portfolio posted solid gains last year, though uneven returns among individual holdings call for some tactical decisions in the new year. The Jan. 5 Utility Roundup included results for each of the 43 companies that graced our Portfolios in 2014. Returns range from a 20 percent paper loss in MDU Resources (NYSE: MDU) to an average gain of almost 50 percent on six positions we sold during the year. A year ago, conventional wisdom assumed that regulated utility stocks would get whacked by the Federal Reserve raising interest rates and lost sales to SolarCity Corp (NSDQ: SCTY) and other proponents of distributed solar power. This expectation enabled us to pick up some of our biggest winners last year on the cheap. Utility stocks find themselves in vogue this year. Exelon Corp (NYSE: EXC), for example, gained more than 40 percent in 2014 and now garners seven buy ratings from Wall Street analysts—up from zero at the year’s outset. But with the Dow Jones Utilities Average trading at almost 19 times earnings, good values are hard to find. Against this backdrop, the Utility Report Card includes more Hold and Sell ratings than at any other time since 2009. Bottom Line: In this late-stage bull market, it’s more critical than ever to stick to stocks that trade below our buy targets to avoid overpaying or taking on too much downside risk. Fortunately, savvy investors can load up on bargains in other essential-services industries...

The stock market has dished out windfall gains and waterfall declines of late, thanks in part to all the upheaval in the energy sector. Fortunately, we’ve enjoyed our share of hefty returns and have experienced only limited downside. Our latest windfall came when NextEra Energy (NYSE: NEE) made Aggressive Income Portfolio holding Hawaiian Electric Industries (NYSE: HE) a takeover offer that the latter couldn’t refuse. The solid performance posted by shares of regulated utilities this fall has been a welcome contrast to the wild action in the energy sector and has kept our Portfolio returns solidly in the black.