Return Of The Macro

Although the Dow Jones Utility Average initially sold off after Donald Trump’s victory in the presidential election, the sector has participated in the broader market rally, levitating despite the prospect of higher interest rates.

This basket of 15 utility stocks has returned more than 10 percent since early December 2016, outperforming the S&P 500 by a few percentage points. Given the Model Portfolios’ exposure to this sector, we’re not complaining.

That said, the Dow Jones Utility Average has reached valuations where the risk-reward balance skews to the downside. In this environment, investors should evaluate the macro forces that could bat these stocks about in coming months.

Learnings from Earnings

As of this week, all but a handful of the more than 200 essential-service companies rated in our Utility Report Card have reported financial results and provided outlooks for future quarters.

The overwhelming majority posted results that met management’s guidance, though disappointments occurred with greater frequency among regional telecoms, where customer attrition from legacy business lines remains a headwind. For this reason, we have Sell ratings on most of these names, including Frontier Communications Corp (NSDQ: FTR), which we downgraded in an Alert issued earlier this month.

Regional telecoms have sought to build scale and offset these challenges through mergers and acquisitions. Pending transactions in the space include Consolidated Communications’ (NSDQ: CNSL) $1.4 billion takeover offer for FairPoint Communications (NSDQ: FRP) and CenturyLinks’ (NYSE: CTL) $33.5 billion bid for Level 3 Communications (NYSE: LVLT).

These deals mask revenue erosion in legacy assets and provide an opportunity to reduce costs. But recent results and guidance suggest that shrinking sales and customer attrition set the stage for another round of dividend cuts. Conservative investors who still own these names should cash out.

Gas and electric utilities continue to thrive, with even long-suffering FirstEnergy Corp (NYSE: FE) taking steps to eliminate its languishing merchant power business to focus on growing its regulated franchise. FirstEnergy Corp rates a Hold for now, but we may upgrade the stock to a buy for aggressive investors as the company makes progress on these plans.

Meanwhile, an increasing number of utilities have accelerated their annual dividend growth to the upper single digits, earning higher valuation multiples in the process. More important, this stepped-up growth reflects opportunities created by increasing demand for renewable energy and natural gas as well as low-risk investments in efficiency improvements.

Over the long run, earnings and dividends growth will drive investors’ total returns in these stocks.