Issues

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.

Volatility sparks fear among investors but also creates opportunities. The October issue of Conrad’s Utility Investor highlighted four ways for readers to profit from an unsettled market:

• Picking up high-quality international equities on the cheap, thanks to the strengthening US dollar;
• Buying when dividend-paying stocks sell off because of misplaced fears about the end of easy money;
• Taking advantage of uncertainty and panic in the energy patch to add to positions in high-quality producers and midstream operators; and
• Buying US utilities that have pulled back because of election-related fears.

Our strategy has already produced some happy returns.

An unsettled market has  rewarded patient investors who kept some powder dry with a number of buying opportunities. Opportunity No. 1: International Intrigue: A strengthening US economy and the Federal Reserve’s push to rein in six years of easy money have boosted the greenback’s value relative to foreign currencies, placing many of our favorite international stocks on the bargain counter. Snap them up now. Opportunity No. 2: Irrational Fear of Rising Interest Rates: The prospect of a stingier Fed has also raised concerns that US interest rates will head significantly higher, undermining returns posted by dividend-paying stocks. I tackle this myth head on and highlight several high-quality telecoms, water companies and electric utilities that have pulled back to favorable price points. Opportunity No. 3: Oil’s Retrenchment: Oil prices have also plummeted of late, fueled by surging US production and elevated refinery outages. This pullback has panicked weaker hands, giving savvy investors an opportunity to buy rock-steady integrated oil companies and first-rate pipeline owners. Opportunity No. 4: Politics as Usual: Uncertainty related to upcoming US elections has likewise unsettled the market and contributed to the market’s recent weakness. We’ll have a full review in the November issue.

By the end of 2016, energy companies will lock in the lion’s share of an estimated $600 billion in contracts for new infrastructure to process and transport surging US oil and gas production to market.   This construction boom creates an unprecedented opportunity for well positioned energy companies such as Dominion Resources (NYSE: D), which recently proposed a 550-mile pipeline to carry cheap shale gas to energy-hungry North Carolina and Virginia. (See Five Big Deals to Build Wealth.)   The pipeline project has stoked the usual opposition from environmentalists and concerned citizens who, by reflect, don’t want any energy-related infrastructure in their backyards.   Ironically, utilities have answered environmentalists’ call for more renewable energy, increasing wind generation from 6 billion to 168 billion kilowatt-hours between 2000 and 2013 and solar-power capacity by 70 percent since 2013. That’s a clear demonstration of how the best US utilities have walked both sides of the street in the debate over fossil fuels and renewable energy. As long as these companies earn a fair return on investment, they’ll continue to reward us with rising earnings and dividends.

While the partisan battle for the US Senate this November makes headlines, the real action for investors is in the gubernatorial elections. Winning governors will appoint state regulators, who set policy for everything from mega-mergers and customer rates to carbon dioxide emissions. Much will depend on what happens in the six states where incumbents look vulnerable: Connecticut, Georgia, Hawaii, Illinois, Kansas and South Carolina. Picking the best opportunities to bet against short sellers helped us to book a 52 percent gain in Windstream Holdings (NSDQ: WIN) and a 58.2 percent profit on Enel (Milan: ENEL, OTC: ENLAY).  We expect our latest addition to the Aggressive Income Portfolio to also confound short sellers and reward us with solid returns.

Since the beginning of May, 80 percent of the companies in our model Portfolios have hit 52-week highs. And the rest are a good day’s trading from this achievement. Our Aggressive Income Portfolio has delivered an average return of 27.5 percent since its inception, roughly doubling the 13.7 percent gain posted by the Dow Jones Utilities Average over equivalent holding periods. Meanwhile, the picks in our Conservative Income Portfolio have generated an average return of 13.4 percent, slightly lagging the benchmark index’s 14 percent gain.

But new risks have emerged that bear monitoring. A growing focus on allowance for funds used during construction (AFDUC) has identified some utilities that may be at risk of potential write-downs. Meanwhile, others find themselves in the crosshairs of the Obama administration’s aggressive environmental policies.

The greatest danger to most of the 207 stocks in my Utility Report Card comes when investors’ expectations rise along with prices. That’s why it’s critical to stick with my buy targets, which are based on long-run value—not near-term momentum.

Be patient when a stock you want to buy moves above my buy target. I will raise those targets when potential returns rise and risks diminish. Until then, focus your firepower on the stocks highlighted in this issue.

There’s nothing like a convincing rally to silence bears. And utilities are still the best- performing sector this year, with the S&P 500 Utilities Index beating the S&P 500 by better than a 2-to-1 margin.

Our three Conrad’s Utility Investor Portfolios—Aggressive Income, Conservative Income and Top 10 DRIPs--have fared well, adding to solid 2013 gains. The biggest winners have been companies that analysts shunned earlier in the year; for example, formerly out of favor Exelon Corp (NYSE: EXC) has returned almost 40 percent.

Outperformance, however, should never be taken for granted. Even in sectors as stable as essential services, the high and mighty frequently change places with the outcasts.

This year is shaping up as a big one for utility mergers. The market value of companies in our Utility Report Card that have announced deals has already reached $237 billion. And Berkshire Hathaway (NYSE: BRK.A, BRK.B) has yet to pull the trigger. (See Buffett Still Eyeing Utilities.)

Thus far, a handful of giants account for virtually all the volume. That includes Aggressive Income Portfolio holding Exelon Corp’s (NYSE: EXC) all-cash bid for Pepco Holdings (NYSE: POM).

The new company immediately gains major synergies in the Mid-Atlantic region, providing financial support for its nuclear power plants in wholesale markets.

I never speculate on takeover stocks that can’t make it on their own--a bias that held me out of Pepco this year. But in the long run, Exelon shareholders will benefit the most from this deal, thanks to a low purchase price and numerous opportunities to upgrade underperforming regulated assets.

As for finding strong companies with takeover appeal, the key is business performance. 

As a long-time shareholder of Berkshire as well as many utilities, I’m encouraged. I’m skeptical of some of the names being floated as MidAmerican’s next potential targets. But the feature article highlights several companies that fit the mold of NV Energy and PacifiCorp, which Berkshire bought in March 2006 from the former ScottishPower.

MidAmerican earned $1.47 billion in 2013 as one of Berkshire’s “Powerhouse Five” non-insurance businesses. That was approximately 7.5 percent of the company’s overall profit, a share that will rise to around 10 percent in 2014, thanks to a full year of owning NV Energy.

Even after the next acquisition, electric utility assets will be less significant to Berkshire’s fortunes than insurance, or even railroads (20 percent of profits). But there are two clear takeaways from Mr. Buffett’s continuing interest in the power sector.

First, MidAmerican is likely to buy another utility this year, handing investors windfall gains. Second, there are regulated electricity assets that still meet the criteria of the world’s most successful value investor.