Issues

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.

The Dow Jones Utility Average hasn’t revisited its Feb. 9 low thus far. But the index is still down almost 15 percent from the all-time high reached in mid-November. Weakness in income-oriented equity groups reflects the pullback in the overall market and fears of rising interest rates. However, at these levels, very few high-quality names in our Utility Report Card remain at unsustainably high valuations and only six of our Model Portfolio holdings trade above our value-based buy targets—a stark contract to only a few months ago. Fourth-quarter results and earnings guidance also underscore that tax reform will provide more of a longer-term tailwind for the utility sector than a near-term headwind. Developments on the regulatory front have also been positive, with Duke Energy Corp (NYSE: DUK) settling its rate amicably and the Texas Public Utility Commission finally approving Sempra Energy’s (NYSE: SRE) takeover of Oncor Electric Delivery. By and large, utilities and the other essential-service companies in our coverage universe reported solid earnings and issued encouraging guidance. Bottom Line: The stocks will only fall so far as weakness in the market and interest rate fears pull them. Although the recent pullback has weighed on our overall returns, investors who followed our lead and took partial profits over the summer should have plenty of dry powder at their disposal.

For the 18th time since World War II, the S&P 500 Utility Index has given up more than 10 percent of its value from its most recent high. Does this pullback represent a healthy breather after a breathless run-up, or the start of a bigger correction? This month’s feature article explores the factors driving recent weakness in utility stocks and the potential for further downside. Over the past year, we’ve emphasized the importance of selling names that show signs of weakness in their underlying businesses and booking partial profits on stocks that have reached unsustainably high valuations. We’ve also taken advantage of the market’s inclination to sell first and ask questions later when valuations become stretched, picking up shares of high-quality names that pull back on temporary hiccups. With utility stocks trending lower, we highlight some of the names that have dropped below our buy targets for the first time in a while. This issue also reintroduces our list of dream prices for all our Portfolio holdings. Our favorite essential-service stocks will only reach these extreme valuations in a flash crash or panic-driven selloff, but this strategy gives us a shot to set ourselves up for windfall gains when there’s blood in the street. Fourth-quarter earnings season is in full swing. You can find our take on results from the 28 companies that have reported thus far in the Utility Report Card. We plan to update our comments on the remainder periodically as earnings come in over the coming weeks; we’ll keep you apprised of our progress via regular updates.

Takeovers, tax reform and President Trump dominated the financial headlines in 2017—and all signs point to this trend continuing well into the new year. When it comes to investment returns, however, quality remains the most important theme. And with valuations still near records, the bull market a year older, and volatility picking up in the utility sector, owning best-in-class names will be more critical than ever to delivering differentiated returns in 2018. This month’s feature article highlights key trends, as well as our picks and pans, for nine categories of essential-service companies. We also revisit our best ideas from the start of 2017; these picks delivered an average total return of 19.6 percent, walloping the 5.8 percent gain posted by our pans. Utility stocks often underperform in January, as portfolio managers allocate more capital to aggressive names. This year, the Dow Jones Utility Average’s performance has taken a hit from concerns that California utilities could face billions of dollars in liabilities related to the catastrophic wildfires that ravaged the state. Although weakness in utility stocks has taken some of our Portfolio holdings down a bit, our position in ProShares UltraShort Utilities (NYSE: SDP) has gained about 15 percent since mid-November. Meanwhile, the pullback in utility stocks has brought a few of our Portfolio holdings below our value-based buy targets. Our commitment to diversification has also paid off, with several of our holdings rallying in the new year despite weakness in utility stocks. Conservative Income Portfolio holding Pembina Pipeline Corp (TSX: PPL, NYSE: PBA), for example, hit a new high last week, benefiting from the rotation into the energy sector. That’s why we stick with stocks that lag in a given year—as long as they’re backed by high-quality businesses. Readers should check out this month’s update to the Utility Report Card, which features our take on how US tax reform will affect the each of the roughly 200 companies in our coverage universe. We also revisit the factors behind our proprietary Quality Grades.  

Wall Street’s eyes are fixed on Pennsylvania Avenue in Washington, DC, where Congress continues to debate major changes to the US tax code. If and when tax reform passes, we’ll post an Alert outlining its implications for our essential-service stocks. At this juncture, we expect more positives than negatives for the names in our Utility Report Card. In cases where the news isn’t so good, investors should remember the aftermath of Canada’s “Halloween Massacre” of 2006, when the government changed the tax treatment of income trusts, eradicating some CA$24 billion in market value in a matter of days. Albeit compelling, this horror story had a happy ending for some investors: the massive returns posted by best-in-class income trusts over the subsequent years. Pembina Pipeline Corp (TSX: PPL, NYSE: PBA), for example, has returned more than 450 percent since those dark days, outperforming the S&P 500 by more than 3 times. This calamity resulted in plenty of pain—and a once-in-a-generation buying opportunity. Although US tax reform may not result in as much destruction, many utility stocks trade at historically elevated valuations, creating an environment where market participants are more likely to sell first and ask questions later. Sharp selloffs in AT&T (NYSE: T) and Dominion Energy (NYSE: D) after earnings hiccups earlier this year created buying opportunities for nimble investors. We remain laser-focused on taking advantage of similar situations in coming months and quarters. Our strategy at Conrad’s Utility Investor continues to focus on buying and holding the highest-quality dividend payers at the best prices. Achieving this goal requires keeping an open mind and poring over quarterly results, earnings call transcripts and trade publications to identify long-term winners and steer clear of the losers. We also attend several industry conferences each year and are always on the lookout for new ways to give our readers an edge.