Issues

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.

Rarely has the difference between leading and lagging stocks been as stark as today, thanks in part to the rise of passive investment strategies and exchange-traded funds that offer one-stop exposure to a sector, industry, or theme. And with the equity market trending higher, investors rightly question why they should go out on a limb by putting your money into an underperformer? Our model Portfolios have benefited from investors’ headlong rush into the utility sector, though 17 of our picks trade above our value-based buy targets. Other stocks can’t seem to catch a break, regardless of their earnings. Historically elevated valuations in the utility sector also create a scenario where investors tend to sell first and ask questions later, a dynamic that can create compelling buying opportunities. Remember what sparked a selloff in Dominion Energy (NYSE: D) in late January and early February 2017? Memory failed me despite all the time I spend in front of a Bloomberg terminal, taking notes on earnings calls and poring over quarterly results—I had to revisit my Feb. 3 Alert for all the gory details. This first-quarter hiccup fades into the background when you consider management’s guidance for stepped-up dividend growth and the stock’s 19 percent total return since that bout of profit-taking. In this market, investors must remain nimble and have the courage of conviction to distinguish real buying opportunities from falling knives—that comes from understanding a company’s underlying business. That’s why we dedicate so much time to analyzing quarterly results in the Utility Report Card and attending industry conferences.  

A record 67 of the 202 companies covered in our Utility Report Card rate a Sell. In some instances, these ratings reflect historically elevated valuations that give investors an opportunity to take profits before the inevitable reversion to the mean. Other Sell calls seek to help investors avoid genuinely weak companies at risk of a major blow-up. Fourteen of these stragglers appear on our Endangered Dividends List. Although many popular, large-capitalization utility stocks trade within a few percentage points of new all-time highs, the list of potential downside catalysts continues to grow. Utilities operating in Florida and on the Gulf Coast, for example, must deal with the aftermath of two of the most destructive hurricanes on record, increasing the risk that their response could fall short of customers and regulators’ expectations. (See Utilities and Hurricanes: Responding to Harvey and Irma.) Concerns about rising interest rates could also provide an excuse to take profits, while the Trump administration has sought to intervene in highly competitive wholesale-electricity markets. Since the September issue of Conrad’s Utility Investor hit the web, Utilities Select Sector SPDR (NYSE: XLU) has lagged the S&P 500 by 6.5 percentage points—a degree of underperformance that could portend further weakness for the sector. On the other hand, the market can remain irrational much longer than investors expect. Moreover, all signs point to a strong earnings season for many of the companies in our Utility Report Card. And buying opportunities still exist at this stage in the cycle. Company-specific developments have prompted us to raise our buy targets on several Portfolio holdings, including this month’s aggressive spotlight. The feature article also identifies which names would benefit from the Trump administration’s proposed intervention in wholesale power markets.

September is often the cruelest month for the stock market, including utilities. This year, however, nothing has broken the sector’s upward momentum, including devastating hurricanes, uncertainty surrounding tax reform, and a pending trade case that could slow the adoption of solar power in the US. We’re not complaining; our Portfolio holdings continue to benefit from this momentum. But the higher bar of expectations that comes with these lofty valuations increases the potential for disappointment. This month’s update to the Utility Report Card uses our proprietary Conrad’s Utility Investor Value Index to compare current valuations to previous peaks in the run-up to the 2000-01 and 2008-09 meltdowns. The biggest takeaway from this exercise is that many utility stocks trade at valuations that exceed these highs. Some of this disconnect between fundamentals and valuations likely stems from the growing popularity of passive investment strategies, a phenomenon we explore at length in the feature article. Nevertheless, we continue to find value in our coverage universe.

With the bull market in its ninth year and equity valuations at historically elevated levels, investors’ growing preference for passive and quantitative strategies seems risky at a time in the cycle when selectivity is critical to success. Giving up this control for lower fees strikes us as a heavy price to pay. Although our favorite utilities proved their worth by maintaining or growing their dividends throughout the Great Recession, these stocks weren’t immune to the gut-wrenching volatility that roiled the market. Weathering the inevitable storms is much easier if you took a little profit off the table when valuations reached unsustainably high levels—a practice we’ve advocated throughout the year. Investors should also remain opportunistic and snap up shares of high-quality companies that temporarily fall out of favor. To this end, we highlight some of our best ideas in the current market. Don’t forget to check out the Utility Report Card for our in-depth analyses of second-quarter results, as well as updated ratings and Quality Grades.

Through the end of the second quarter, more than half the roughly 200 companies covered in our Utility Report Card increased their dividends at least once. Fifteen cut their payouts over this period. About three-quarters of our coverage universe are in the black this year. Lofty valuations on last year’s winners make it much harder for even the strongest names to make significant headway this year—a reason for investors to stay disciplined and stick to our value-based buy targets. The Dow Jones Utility Average historically has struggled to trade at these elevated levels without suffering a reversion to the mean. Whether the benchmark index’s 5 percent decline from its June high marks a real tipping point remains to be seen, though the recent action bears a strong resemblance to the selloff that occurred last summer. Meanwhile, another tipping point for electric utilities has appeared on the horizon: Recent trends suggest that over the coming decade, unsubsidized solar- and wind-power projects will be able to compete on cost with existing coal- and gas-fired power plants. This topic figured prominently at a launch event for Bloomberg New Energy Finance’s recently published energy outlook and at the Energy Information Administration’s annual conference. I attended both and share some of my top takeaways in this issue. Although investors should always view long-term forecasts with skepticism, electric utilities’ investment plans and strategic decisions suggest that the rise of renewable energy could be a real profit driver for the sector, especially when paired with efficiency initiatives.

The Dow Jones Utility Average hit an all-time high this month, raising the bar of expectations to levels that will be difficult to meet, let alone beat. Investors may be in for a bit of déjà vu: The sector last reached these lofty heights in summer 2016, at which point the Dow Jones Utility Average suffered a roughly 15 percent pullback. This correction propelled our position in ProShares UltraShort Utilities (NYSE: SDP)—an exchange-traded fund that’s designed to deliver 2 times the Dow Jones US Utilities Index’s inverse daily return—to a roughly 25 percent profit. Over the past year, these gains have evaporated with the sector’s run-up. But with the Dow Jones Utility Average trading at historically unsustainable valuations, we’re comfortable holding a hedge position that will thrive when the sector inevitably reverts to the mean. Will utility stocks suffer a pullback this summer? The answer depends, to a large extent, on the direction of the US stock market, which has climbed higher while shrugging off political turmoil and middling economic growth. Most of the companies covered in our Utility Report Card will report second-quarter results in late July and early August, creating the potential for company-specific sell-offs. The Federal Reserve’s monetary policy could also give investors an excuse to take profits; however flawed, the conventional wisdom holds that rising interest rates represent a headwind for utility stocks and other dividend-paying equities. Of course, the market can always remain irrational for months—or even years. Although many of our Portfolio holdings trade above our buy targets (a high-quality problem), the market isn’t bereft of opportunities—this issue highlights some of our favorite investment ideas. That said, investors may want to consider taking a partial profit off the table in some of their highest flyers. Better buying opportunities will come again.

This month’s update to the Utility Report Card includes our analysis of first-quarter earnings and guidance for more than 200 essential-service stocks, while the feature article delves into some of the key trends that emerged during this exhaustive process. With utility stocks still trading at elevated valuations, our investment strategy hasn’t changed appreciably; investors should remain disciplined and avoid chasing stocks beyond our value-based buy targets. At the same time, solid first-quarter results underscore the strong fundamentals that should drive above-average earnings and dividend growth for our favorite utility stocks. Sentiment toward utility stocks remains bullish. NextEra Energy’s (NYSE: NEE) share price rallied to a new all-time high, despite the Public Utility Commission of Texas rejecting its proposed purchase of Oncor Electric Delivery—the company’s second deal failure in two years. But high valuations create lofty expectations, increasing the likelihood that investors will view any hiccup, real or imagined, as an excuse to take profits.