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Investment Strategy

Utility Stocks and the Burden of High Valuations

By Roger S. Conrad on Jan. 17, 2015

Editor’s Note: Join Elliott Gue and Roger Conrad at the World MoneyShow Orlando, Feb. 4 – Feb. 7 at the Gaylord Palms Resort. The investment mavens behind Capitalist Times, Conrad’s Utility Investor and Energy & Income Advisor will share their market outlook and best ideas for these uncertain times. Don’t miss out on this must-attend event. Register for free on the MoneyShow site to reserve your place at the conference.

Utility stocks outperformed handily in 2014—a surprise to naysayers who warned that rising interest rates and growing adoption of distributed solar power would weigh heavily on the group.

Meanwhile, the wholesale rout in the energy sector has driven capital to the utility sector and other perceived safe havens.

The Dow Jones Utilities Average rewarded investors with a 30.7 percent total return last year, its best performance since 2000 and three times the gain posted by the Dow Jones Industrial Average.

Everyone loves a winner. And although investors aren’t universally bullish on the sector, utility stocks are far more popular than a year ago. Thus far in 2015, the S&P 500 has pulled back 1.8 percent and the Alerian MLP Index has dropped 4.5 percent; the Dow Jones Utilities Average, on the other hand, has climbed by almost 3.7 percent.

But popularity carries a price: a higher bar of expectations and elevated downside risk when investors regard any hiccup as any excuse to take profits.

Check out our table comparing the Dow Jones Utilities Average’s current valuations to its pre-crisis top in early 2008 and its post-crash bottom in early 2009.

UTIL Index Valuation Table

On a price-to-earnings basis, the utility sector looks more expensive relative to the pre-crash top in early 2008. In fact, the last time the Dow Jones Utilities Average fetched a higher multiple occurred in late 2000, when high-flying Enron had utilities levering up to keep pace.

The benchmark index also trades at its highest price to cash flow—defined as earnings before interest, taxes, depreciation and amortization (EBITDA)—since at least the end of 2002. Back then, the Dow Jones Utilities Average’s enterprise value to EBITDA stood at 6.86—35 percent below the index’s current multiple of 10.58.

For the most part, however, the Dow Jones Utilities Average trades at valuations that are below its previous top and well above previous troughs.

Adding Real Value

I’ve analyzed utilities and picked stocks in this sector for almost 30 years; I’d argue that these businesses have added significant value since 2008 or, for that matter, before and after the 2001-02 crash.

The sector has improved its gross margins by almost 20 percent since 2008, though its return on equity (ROE) is markedly lower, largely because of the decline in interest rates.

In fact, the difference between earned ROEs and utilities’ 30-year borrowing rates suggests that the sector’s allowed returns hover near an all-time high.

Moreover, the Dow Jones Utilities Average’s ROE has improved considerably since bottoming at 7.29 percent in 2012. The consensus expectation calls for the sector’s ROE to return to double digits this year.

Utility stocks took a big hit with the rest of the stock market in 2008. But from a business perspective, the real bottom occurred in late 2002, not early 2009. In the aftermath of Enron’s implosion, about two dozen companies had declared bankruptcy or were perilously close to throwing in the towel.

Utility Strong

The turnaround that occurred over the subsequent 13 years is remarkable by any standard. A new generation of management teams committed to strengthening balance sheets and cutting operational risk by getting back to basics.

This process involved maximizing returns in regulated business lines and exiting noncore operations. Some utilities have endured a long road to recovery. But even the sector’s weakest survivors have clawed their way to much sounder ground. As a result, utilities weathered the 2008 credit crunch with relative aplomb.

The four utilities that cut their dividend between 2007 and 2009 still had substantial exposure to the operations that brought the sector to its knees in the early 2000s.

Armed with much stronger balance sheets and focused on their regulated operations, most utilities continued to raise their dividends during the Great Recession.

And the utility sector continues to cut risk.

Duke Energy Corp (NYSE: DUK) and Edison International (NYSE: EIX), for example, exited the wholesale-power business over the past year. And American Electric Power (NYSE: AEP) is reportedly shopping its remaining unregulated power plants.

Regulatory Relations

Utilities’ profitability depends on maintaining good relations with state regulators who set policies and determine the allowed return on equity.

Last year’s gubernatorial elections delivered almost universally favorable outcomes for utilities, while relations with regulators remain salutary in most states.

(Click map to enlarge.)Regulation Map

When I began covering utility stocks in the 1980s, state regulators often took a combative approach toward the companies that provide power, natural gas, water and communications services.

Prudency reviews, for example, called into question investments made years earlier. The typical rate case took at least a year to resolve, with companies often winning meager returns on only a fraction of money they’d invested.

This toxic atmosphere peaked in the early 1990s, when states began to consider deregulation as a way to lower utility rates.

But by 2001, spiking power prices in California and Nevada and the collapse of Enron had triggered a rethinking of the relationship.

Although utility-regulator relations remain strained in New York and a handful of other states, essential-service providers won’t invest in system enhancements and expansions unless they have an assurance of earning a fair return.

At the state level, utilities haven’t enjoyed such a friendly regulatory environment since the 1950s.

As for the federal government, the Environmental Protection Agency’s proposed rules for cutting carbon dioxide emissions will create a financial burden for some—assuming that no changes are made to version circulated for public comment and state regulators don’t help out with rate increases. (See EPA’s Crackdown on CO2 Emissions: An Indecent Proposal?)

The Federal Energy Regulatory Commission (FERC) has also trimmed allowed returns for power transmission lines. ROEs, however, remain in double-digits and easily exceed the 4 percent that utilities pay on new 30-year bonds. And FERC continues to approve mergers and new projects expeditiously.

Solar Flair

Even rooftop solar has evolved from a threat to an opportunity, as a growing number of utilities adapt the distributed-power model and undercut the increasingly unprofitable SolarCity Corp (NSDQ: SCTY).

Regulators have supported these moves. Arizona officials, for example, approved Pinnacle West Capital Corp’s (NYSE: PNW) plan to offer low-cost rooftop solar installations and changed net-metering rules in the company’s favor.

Value and Expectations

But after last year’s run, utility stocks have priced in a great deal of good news.

My Utility Report Card, available exclusively to Conrad’s Utility Investor Subscribers, reflects these lofty expectations; our coverage universe of more than 200 essential-services stocks includes more Hold and Sell ratings than at any other time since 2009.

CUI-Evergreen

That’s not to suggest that utilities are due for a major selloff. In fact, the sector’s reputation for safety makes these stocks everything income-seeking investors want in a world where even midstream master limited partnerships’ distributions have come under suspicion.

Utility stocks could climb higher in 2015, especially if investors continue to pour money into US Treasuries, keeping a lid on interest rates.

And interest rates may remain low for a while longer, as any move by the Federal Reserve to boost the benchmark rate will strengthen the greenback’s value relative to international currencies, encouraging foreign investors to pour more money into US equities and Treasury securities.

Although the correlation between utility stocks and changes in interest rates remains tenuous at best over the long term, a low rate environment should boost the sector’s near-term appeal.

Rising expectations, however, are more of a concern: Higher valuation multiples increase the risk that investors will view any hiccup as an opportunity to take profits. And at these levels, most utility stocks offer a combination of yield and dividend growth that isn’t worth chasing.

A Strategic Shift

Over the years, utility stocks have rewarded investors who buy and hold throughout market cycles. Strong businesses increase their dividends consistently, driving share prices higher. All we have to do is be patient during the ups and downs, and make sure our holdings’ underlying businesses stay on track.

Nothing has changed on that score. Our Conservative Income Portfolio and Top 10 DRIPs (dividend reinvestment plans) still follow this approach.

CUI Performance Video

But late-stage bull markets are famous for dramatic swings in momentum. And the growing popularity of exchange-traded funds can exaggerate moves to the upside and the downside.

In light of these risks, investors should have no qualms about taking what the market gives them and booking profits that amount to several years’ worth of accumulated dividends

Last month, we sold SCANA Corp (NYSE: SCG) from our Conservative Income Portfolio at a price that was almost $10 higher than our buy target, booking the equivalent of 19 quarterly dividends in one fell swoop.

We made this call after the announced sales of noncore telecom and pipeline assets squeezed the stock price beyond its already elevated levels. SCANA’s shares now yield 3.4 percent at a time when the potential for cost overruns at its Summer nuclear power project threaten to slow the rate of dividend growth.

At this juncture, sector rotation into utilities is the only identifiable upside catalyst for SCANA’s stock. This trend may lift the share price higher.

But if sentiment cools for whatever reason—news regarding further delays and higher construction costs at Summer or misplaced concerns about the implications of rising interest rates for dividend-paying stocks—will send the shares spiraling lower in short order.

In the event of such a selloff, the stock could bottom around $50 per share—a resistance point that the shares held for much of 2013 and a good portion of 2014.

The January 2015 issue of Conrad’s Utility Investor highlights seven big winners (gains of at least 40 percent) in our model Portfolios that will be ripe for profit taking if their stock prices continue to rally.All these stocks trade above our buy targets, at prices that are much higher than any value-conscious investor should be willing to pay.

Not every investor will want to follow my lead. And history has demonstrated that as long as these businesses stay strong, they’ll come through each market cycle on higher ground. Just stick through the ups and downs and your wealth will build steadily over time.

Buying and holding remains my primary strategy for my personal holdings and running the model Portfolios in Conrad’s Utility Investor.

But by taking money off the table in some high-priced stocks, we book what amounts to years of dividends in advance and insulate ourselves from any downside when investors rotate out of the utility sector. We can also redeploy the proceeds from these sales into stocks that trade at reasonable valuations and offer more near-term upside potential.

That tactic still makes sense even if this bull market that began in March 2009 still has a couple more years left in the tank.

MODEL PORTFOLIOS & RATINGS

ABOUT ROGER CONRAD

Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b