Issues

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.

It appears all the president’s men can’t put King Coal back together again. Once again, US electric utilities have collectively yawned at a Trump Administration proposal to revive coal-fired power in the US, this time by stripping away regulations on plant upgrades to discourage shutdowns of older facilities. Formerly one of the world’s largest users of coal, Duke Energy (NYSE: DUK) this month filed in North Carolina to speed up the closure of three large facilities by six years to 2024. The utility now plans to ultimately replace all coal capacity with cheaper natural gas, and a combination of wind, solar and energy storage increasingly favored by its regulators.

When I started in this business, individual investors dominated daily trading. Now, even decisions by professional stock pickers are eclipsed by passively run pools of capital, governed by algorithms executed by artificial intelligence. The consensus seems to be this is simply the next phase of evolution. After all, computers trade at multiples the speed of ordinary humans and without the emotion that’s often the biggest failing of investors. The problem is capital governed by algorithm faces the same conundrum as do large funds run by managers: The larger the pool, the smaller the list of stocks available to trade without moving the market, no matter how sophisticated the programming. And that’s leaving aside the fact that many algorithms are written with similar objectives--i.e. to beat the S&P 500 and other benchmarks—and are therefore likely to take similar actions at the same time. We’ve yet to see passive investing strategies tested in a crisis. But we already know that over any meaningful period of years, pools of capital using passive strategies such as the Vanguard Target Retirement funds have dramatically underperformed market averages. We also know that price momentum created by passive strategies creates opportunities to buy lower and sell higher than in previous market cycles. Taking advantage does require knowing whether a fallen company is still strong on the inside, or if a high flyer has exceeded any reasonable gauge of value and is likely to take a tumble. But by following a disciplined strategy of seeking quality and waiting for the right price, we’re going to find many more opportunities like March Focus stock AES Corp (NYSE: AES), which has since returned upwards of 30 percent.

First half 2018 is in the books. Like the broad stock market, CUI Portfolio and coverage universe stocks experienced a great deal of sound and fury, most of which amounted to very little. The feature article highlights key trends for the nine sub-sectors represented in the Utility Report Card, and updates performance of the picks and pans from the January issue. Portfolio Update analyzes the basically flat showing of our Conservative, Aggressive and Top 10 DRIPs recommendations. Considering last year’s strong gains and the general market turmoil so far in 2018, breakeven isn’t a particularly poor result. We’ve also taken advantage of volatility to add high quality companies to the Portfolios at good prices: Comcast Corp (NSDQ: CMCSA), Sempra Energy (NYSE: SRE) and TerraForm Power (NSDQ: TERP). This month’s featured stocks AT&T Inc (NYSE: T) and Telefonica SA (Spain: TEF, NYSE: TEF) present an equally compelling opportunity to buy low. And like the above trio, they offer big potential second half gains, as headwinds depressing returns lose their force. Each is likely to get a boost sometime in the next several weeks after releasing solid second quarter results and guidance. And I’ll recap highlights and share my analysis in Utility Report Card as they report. Utility investors are also going to want to watch approaching November 2018 elections. Media focus will be on the battle for control of Congress. But as always, state results are what’s critical for our coverage universe. That’s because governors and state legislatures make the laws and appoint the regulators who set utilities’ investment and returns.

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.

Bullish: That’s the key takeaway from first quarter results of the roughly 50 percent of Utility Report Card companies reporting to date.

Focus stocks BCE Inc (TSX: BCE, NYSE: BCE) and Amerigas Partners (NYSE: APU) had especially good news. So did the energy utilities highlighted in Portfolio Update and the best in class telecoms of the sector-intensive Feature article.

As Endangered Dividends reveals, not every company had a strong report. That includes Aggressive Holding Buckeye Partners (NYSE: BPL), and we’re taking action. The greater risk to portfolios now, however, is from a growing number of stocks’ extreme valuations.

The return to very high prices wouldn’t have been possible without the three-months-old uptrend in utility stock averages. As has been the case the last few cycles, growth has enabled the sector to shrug off worries about rising interest rates. Since early February, the Dow Jones Utility Average has returned 10 percent, versus less than 4 percent for the S&P 500.

A more important reason for caution, however, is newly resurgent utility takeover fever. Market reaction has been lukewarm to the biggest deal so far this year, the proposed union of wireless giants Sprint (NYSE: S) and T-Mobile USA (NSDQ: TMUS).

From potential trade wars to a possible hot war in the Middle East, the stock market has encountered numerous headline risks since early February. Meanwhile, the US economy continues to grow at a solid clip and inflation remains in check—sure-fire fuel for a bull market. Investors should continue to focus on fundamentals, especially the health of the companies represented in their portfolios. Our proprietary Quality Grades rate the more than 200 essential-service companies covered in our Utility Report Card from A (best) to F (worst). We break down the criteria that factor into our grading system and highlight several names on our watch list for potential inclusion in our model portfolios. In recent months, we’ve taken advantage of temporary selloffs in names with high-quality franchises and encouraging growth prospects. Recent portfolio additions Comcast Corp (NSDQ: CMCSA) and Edison International (NYSE: EIX) still offer good value for savvy investors, while recent weakness in Dominion Energy (NYSE: D) strikes us as unwarranted and overdone. Although the Utility Report Cardcontains fewer Sell-rated stocks after the recent pullback in the utility sector, investors should continue to steer clear of the names on our Endangered Dividends List.