Issues

The Dow Jones Utility Average hit an all-time high in late June, backed off and is rallying again. The price-weighted index now sells for nearly 22 times trailing 12-months earnings and yields barely 3 percent.

The last time utilities yielded this little was just before the 2007-09 bear market. The only time since the early 1960s the P/E was this high was at the end of 2000, before a nearly 60 percent crash in the wake of Enron’s collapse.

Utility sector business fundamentals have rarely if ever been more secure. That’s the clear message from the break down of my five-part Quality Grade system, which I present in the Utility Report Card. The latest shot in the arm is a steep drop in essential service companies’ borrowing costs.

Buy American, buy safety and buy yield: Those are three powerful upside drivers for utility stocks this spring, as major sector averages have made one new high after another.

Investors who choose to run with the bulls now, however, should have an extra ounce of caution. Not only are utility stock valuations at levels we haven’t seen since late 2000.

But as I point out in the Feature article, much of the buying power behind the rise doesn’t actually stem from decisions made by individual investors or even money managers. It’s the result of buy signals for algorithms that control vast and growing pools of “passively managed” money.

The fear the US/China trade deal might not get done is again roiling the global stock market. So far, however, selling hasn’t done enough to budge top quality utility stocks from their still historically high valuations.

High prices alone never kill bull markets. But it’s all too easy to disappoint the lofty investor expectations they represent. And risk is never higher than when companies are reporting quarterly earnings and issuing guidance.

This month’s Utility Report Card highlights my analysis of results for the roughly two-thirds of our coverage universe that’s responded to date. The really good news is that so far Portfolio recommendations are sticking to calendar year 2019 guidance, even in cases where weather and non-recurring events have depressed quarterly bottom lines.

2019 has started out with a bang for utilities and essential services stocks. The Dow Jones Utility Average’s 10.2 percent first quarter return was one of its best showings in history. And the 38 stocks in our Conservative Holdings, Aggressive Holdings and Top 10 DRIPS are higher by 15 percent.

This positive momentum is certainly a welcome change from lackluster 2018, and particularly the vicious fourth quarter selloff. But it also brings reasons for investors to be wary.

First, really big openings followed by fantastic finishes are extremely rare for utilities, the most recent being in 2000. Typically, stock prices level off in the following months. I’m encouraged that our Portfolio gains were more driven by positive business developments at individual holdings than the sector surge. But with the DJUA marking a new all-time high last month, utility valuations are back in the stratosphere.

From all indications, most Utility Report Card companies should report strong first quarter earnings and guidance updates in the coming weeks. But catalysts for further upside now face a high bar. It’s also noteworthy that more than a few best in class names lagged in the first quarter, despite very strong business performance.

As I pointed out in the March 21 Income Insights “The Fed Turns a Page,” the Federal Reserve’s decision to terminate its monetary tightening cycle carries a huge positive for capital intensive companies like utilities: A big drop in borrowing costs that’s provided a fresh opportunity to lock in cheap, long-term financing. This month’s Utility Report Card comments highlight this advantage, as well as analysis of other Quality Grade criteria.

There are only a few weeks left in first quarter 2019. And still a handful of Utility Report Card coverage universe companies haven’t reported calendar fourth quarter numbers and guidance.

Unfortunately, tardy filings are par for the course this time of year, when most companies make full-on annual reports rather than quarterly updates. But there’s already been plenty revealed that has critical implications for investors during the rest of 2019.

This month’s Report Card has the particulars for almost all of the companies that didn’t report in time for the February issue. Putting together everything we’ve learned so far, the most important takeaway is, to a company, our Portfolio recommendations didn’t disappoint.

In fact, Aggressive Holding Hannon Armstrong Sustainable Infrastructure Capital (NYSE: HASI) justified our faith holding onto it over the past year by returning to dividend growth. That news pushed its shares to a new all-time high this month. And as the “Portfolio Holdings Trading Above Target” table in the Portfolio Article shows, it’s hardly alone in making a run.

For the 20^th time since 1984, the Dow Jones Utility Average has posted positive January returns. Only in 1987 and 2015 did utilities fail to follow such a performance with an up year. Two good reasons best in class companies should succeed in 2019: More modest valuations than a year ago and strong earnings. Utility Report Card has highlights and analysis for the roughly one-third of coverage universe companies that have reported calendar fourth quarter results. So far, most have come in at or ahead of where management was guiding. There’s still a lot more news and numbers to come, including potentially make or break reports from several Conrad’s Utility Investor Portfolio recommendations. What we see will be even more critical for several Endangered Dividends List companies, which now sit on a knife’s edge between maintaining and cutting dividends. This month, I’ve again focused the Feature article on the most promising highest yielders. Returns from the last time I tried this back in August were solid on balance but a mixed bag.

A year ago, I highlighted “lofty expectations” as the primary danger to the Conrad’s Utility Investor coverage universe. That risk is no longer so acute after a year of generally robust earnings and sliding share prices. Rather, the key question is whether companies can maintain profit and dividend growth momentum, should the macro environment darken in 2019 as so many fear. And certainly there are plenty of causes for concern on that front, ranging from trade tariffs and potential fallout from a record-long US government shutdown to still-tightening monetary policy. This month’s Utility Report Card highlights how all 200-plus companies we track stack up on the five criteria behind our Quality Grades: Dividend growth sustainability, revenue reliability, regulatory relations, refinancing/financing ability and operating efficiency. As the 2018 returns shown in the comments also demonstrate, even A-rated companies meeting all five can see red ink in a given year. But being strong on the inside is the best forecaster for an eventual recovery. And it’s also the most effective protection for investors if the economy and stock market resume their vicious pre-Christmas holiday slide. This is also the time of year when we publish our sector-by-sector forecast, along with picks and pans for each in the coming year. Last year’s favored stocks once again beat the bad and ugly, though almost everything followed the overall market underwater. I expect a much better result this year, in large part because investor expectations are far lower across the board for essential services companies.

So far in fourth quarter 2018, the Dow Jones Utility Average has returned 5.4 percent. That’s against a -9.3 percent loss by the S&P 500. Utilities are also now well ahead for the full year, after lagging behind for most of it. I’m not surprised money is flowing into essential service companies, given the level of investor fear of a potential recession, bear market and US/China trade war. And utilities’ strong third quarter results, which I again highlight in the Utility Report Card, confirm their businesses will hold up again if the worst does happen. On the other hand, this is a world where stock market ownership has been increasingly concentrated into fewer hands. In this case, it’s giant exchange traded funds that are managed by passive strategies, governed by what appear to be remarkably similar algorithms. That means a lot of money moves in a hurry, and not always for good reason. Favorite stocks like NextEra Energy (NYSE: NEE), for example, have been driven relentlessly higher to nosebleed valuations. Meanwhile, “risk off” moves have tanked most high yielders, most recently Amerigas Partners (NYSE: APU).

The Dow Jones Utility Average finished the month of October up 1.9 percent. That was almost 9 percentage points better than the S&P 500, and despite rising interest rates. Historically, a positive October for utilities has meant a solid finish to the year. This time, the sector will have two other potential catalysts to help it along: Strong third quarter earnings and guidance, and what appear to be mostly supportive outcomes from the recent nationwide elections. I highlight numbers and guidance for the 200 plus essential service companies of our coverage universe in the Utility Report Card.

The Dow Jones Utility Average has posted positive returns in 35 Octobers and 38 fourth quarters since 1969. This year, it will try to repeat that with the benchmark 10-year Treasury note yield (TNX) rising to its highest level in seven years. Powerful DJUA returns in 2009 and 2013 against 70 percent plus increases in the TNX demonstrate dividend-paying stocks can make big money when rates rise. So does the DJUA’s 60 percent return during the previous Federal Reserve tightening cycle in 2004-06, and utilities’ nearly 70 percent since May 1, 2013, when the Fed declared the end of Quantitative Easing. Rate fears, however, can be a near-term headwind.