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Investment Strategy

Utility Stocks: Where We’ve Been and Where We’re Headed

By Roger S. Conrad on Aug. 4, 2015

Editor’s Note: Nate Conrad, my eldest son, is spending the summer in China as part of Princeton in Beijing, an intensive language study program. To share his experience with our family and organize his thoughts about life in China’s capital city, Nate started a weekly blog chronicling his summer abroad. We’re hosting the blog on the Capitalist Times website; readers interested in learning more about everyday life in Beijing can check out Nate’s Beijing Diaries.

In April 2013, I left my job of 25 years as founding editor of Utility Forecaster to form my own publishing company and write the investment newsletter of my dreams: Conrad’s Utility Investor.

The publication’s second birthday—the first issue came out on Aug. 1, 2013—is as good a time as any to review where the utility sector and other essential-services stocks have been and my outlook for where they’re headed.

Over the past two years, shares of utilities, telecommunication providers and midstream master limited partnerships (MLP) have endured their fair share of ups and downs.

(Click graph to enlarge.)AMZ S5TELS UTIL TRA Roger Conrad

The shale oil and gas revolution, the collapse in global energy prices, fears of rising interest rates, and a halting economic recovery from the Great Recession have stoked volatility over this period.

In addition to these big-picture developments, myriad industry-, country- and company-specific factor have separated the winners from the losers in my Utility Report Card, an exclusive feature that includes my ratings, comments and vital statistics for more than 215 essential-services stocks.

An uptick in mergers and acquisitions has been a major upside driver over the past 12 months, while the Environmental Protection Agency’s (EPA) recently announced rules to curb greenhouse-gas emissions create opportunities for some and challenges for others. Competition in the telecom business continues to intensify, ratcheting up the pressure on the small fry. Severe droughts in Brazil and California have also created headwinds for some utilities.

The track record of our Conservative Income Portfolio and Aggressive Income Portfolio is a testament to our focus on quality and valuations while taking calculated bets on riskier fare.

Since Conrad’s Utility Investor launched in August 2013, we’ve exited 10 positions for an average return of 31 percent: eight to lock in profits on stocks that rallied beyond our buy targets and two to prevent small losses from becoming larger ones:

  • 07/13/15: ONE Gas (NYSE: OGS)—36% Profit;
  • 06/07/15: CenturyLink (NYSE: CTL)—14% Loss;
  • 06/07/15: Hawaiian Electric Industries (NYSE: HE)—29% Gain
  • 04/06/15: Companhia Energetic de Minas Gerais (NYSE: CIG)—14% Loss;
  • 12/19/14: SCANA Corp (NYSE: SCG)—32% Profit;
  • 11/28/14: Kinder Morgan Energy Partners LP (NYSE: KMP)—34% Profit;
  • 11/28/15: Kinder Morgan Management LLC (NYSE: KMR)—44% Profit;
  • 09/12/14: Consolidated Communications (NSDQ: CNSL)—54% Profit;
  • 08/04/14: Windstream Holdings (NSDQ: WIN)—53% Profit; and
  • 03/07/14: Enel (OTC: ENLAY)—58% Profit.

For income-seeking investors who prefer to buy, hold and collect dividends, taking profits (or a loss) on a position is anathema. Some consider selling one of their holdings akin to turning their back on a reliable old friend. And unless there’s a readily available alternative to replace the lost income from the vacancy in their portfolio, many simply won’t do it.

Believe me. I understand. My risk-adjusted returns over the past 10 years put me in 1st place overall in Hulbert Financial Digest’s running tally of the best investment newsletters—patience and a cool head have been and remain integral to my success.

Like all investors, I’m intensely interested in improving future performance by learning from past mistakes. In some ways, knowing when to sell a position is the easy part—actually pulling the trigger can be a challenge.

Taking profits when the risk-reward balance skews toward the downside has made a huge difference in this up and down environment, enabling us to lock in gains before they evaporated and limi our losses.

With second-quarter earnings season in full swing, I’m poring over press releases and regulatory filings and listening to conference calls in the never-ending search for potential risks and opportunities.

Subscribers can find my in-depth analysis for our portfolio holdings’ quarterly results in the Utility Roundup section and the August issue of Conrad’s Utility Investor. The next update to the Utility Report Card—slated for later this week–will include my analysis of quarterly earnings for the names that have reported.

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As we move into the second half of 2015 and beyond, I’m on high alert for best-in-class stocks that sink to bargain levels—and names that have given us all we can reasonably expect and are candidates for taking profits.

Here’s a look at some of the big-picture trends that will influence earnings, dividends and share prices for the more than 200 essential-services companies covered in my Utility Report Card.

Trend No. 1: Fear of Rising Interest Rates Becomes Less of a Factor in Second Half

Readers who review the inaugural issue of Conrad’s Utility Investor from August 2013 will have a sense of déjà vu: We warned that fears of rising interest rates had spurred selling of dividend-paying stocks and emphasized the importance of buying high-quality stocks at low prices.

As it turned out, economic softness squelched concerns about a potential uptick in US interest rates, setting the stage for a recovery in utility stocks.

Our patient value hunting gave us opportunities to cash out of some holdings for solid gains and left us with a well-balanced portfolio that has held its own despite a 13 percent decline in the Dow Jones Utilities Average since later January 2015.

Recent volatility in utility stocks and other dividend-paying fare underscores the extent to which expectations for the Federal Reserve’s policy on interest rates continue to drive trading activity. We expect these fears to dissipate.

For one, market history demonstrates scant correlation between movements in interest rates and annual returns generated by the Dow Jones Utilities Index. (See 3 Reasons Not to Sweat The Fed’s Latest Taper Tantrum.) Unlike bonds and other fixed-income securities, stock prices tend to follow earnings and dividends, which depend on the health of a company’s underlying business.

An uptick in interest rates can increase borrowing costs, a concern for heavily leveraged companies that operate deteriorating or marginal businesses. Moreover, a sustainable increase in interest rates must be backed up by economic growth that lifts demand for money; this strength will improve companies’ ability to offset higher interest rates, especially regulated utilities whose allowed returns on equity rise with borrowing costs.

And the market has already price in at least one increase to the federal funds rate—and possibly two or three. Global economic weakness and potential deflation will also constrain the US central bank from an aggressive approach to normalizing monetary policy.

The strengthening US dollar, for example, has already hurt American businesses that export to international markets and hurt the developing world, especially for emerging economies with sovereign and corporate bonds denominated in US dollars.

Chairwoman Janet Yellen and a majority of Fed governors have reiterated that the central bank won’t act precipitously in its quest to normalize monetary policy. Investors who have insisted on betting the other way have been burned, repeatedly.

Trend No. 2: M&A Activity and Spin-Offs Remain Powerful Catalysts

The history of the US utility sector is one of consolidation. More recently, low costs of capital and an abundance of needed system investment have helped to accelerate mergers and acquisitions activity.

For investors, the payoff is twofold: Takeover offers usually involve a healthy premium, and these combinations rarely (if ever) fail to create a stronger company. Windfall gains, solid dividend growth and long-term capital appreciation are enough to make any investor salivate over utility mergers.

I recently highlighted my top takeover picks in a special report for Conrad’s Utility Investor subscribers. Not a subscriber? Sign up for a risk-free trial today and receive instant access to my Top 5 Utility Takeover Plays. Subscribing today will also enable you to attend my next Live Chat for subscribers, a quarterly event that lasts until I’ve answered every question.

Trend No. 3: System Investment Drives Earnings Growth

Michigan-based utility CMS Energy Corp (NYSE: CMS) recently reaffirmed its guidance for long-term annual earnings growth of 5 percent to 7 percent, backed by plans to invest $15 billion to $20 billion in capital over the next decade.

American Electric Power (NYSE: AEP) also raised its 2015 guidance, citing a $200 million increase in transmission-related capital investments.

And despite write-offs on two major projects, Southern Company’s (NYSE: SO) system investments helped the utility to deliver earnings growth of almost 5 percent in the second quarter.

This handful of recent examples underscores the importance of capital expenditures—and a salutary regulatory environment—to electric utilities’ earnings and dividend growth.

The same principle holds in the telecom sector, where juggernauts AT&T (NYSE: T) and Verizon Communications (NYSE: VZ) continue to invest huge sums in their industry-leading wireless networks while still generating ample cash flow to pay down debt and reward shareholders with generous dividends and stock buybacks.

AT&T and Verizon Communications’ superior network quality also helps them to reduce customer attrition and attract high-margin customers.

Trend No. 4: Depressed Natural-Gas Prices Remain Headwind for Wholesale Power

Exelon Corp (NYSE: EXC) was the first power company with significant exposure to the wholesale-electricity market to report second-quarter results. Although the firm grew its earnings by 15.7 percent year over year, these impressive results occurred despite weakness in the spot market for electricity.

Expect this headwind to show up in the results posted by the likes of Calpine Corp (NYSE: CPN), Dynegy (NYSE: DYN) and NRG Energy (NYSE: NRG) for the rest of the year. Their stocks have already price in a great deal of downside, but any improvement in market fundamentals could take a long time to materialize.

Average monthly power prices in New England hit an all-time low in June, hitting the profitability of nuclear power plants owned by Dominion Resources (NYSE: D), Entergy Corp (NYSE: ETR) and NextEra Energy (NYSE: NEE). But this challenge represents little more than a slight hiccup for these well-diversified names.

Trend No. 5: EPA Rules on Greenhouse-Gas Emissions Bullish for Renewables and Gas-Fired Generation

The EPA’s final rules for curbing greenhouse-gas emissions favor renewable energy and gas-fired generation.

Although the plan gives states an extra two years to comply with federal mandates, the end result is the same as the draft version published last year: a quantum shift in the US generation mix away from coal.

Politics will determine whether the EPA’s new rules survive; a Republican victory in the 2016 presidential election would almost certainly lead to their repeal.

However, utilities have already started to make the necessary investments to comply with these rules, led by the companies that own and operate sizable fleets of coal-fired power plants.

Investments in commercial-scale and rooftop solar power have entered utilities’ rate bases around the country, and utilities continue to take advantage of America’s abundant supply of inexpensive natural gas to build new power plants and pipelines.

Natural gas emits almost half as much carbon dioxide as coal when used as feedstock to generate an equivalent amount of power.

Renewable sources of power generation don’t emit any carbon dioxide, but their intermittent nature and expense mean that gas-fired plants likely will become an important source of baseload generation to balance the grid when the sun isn’t shining or the wind isn’t blowing.

All these investments should boost utilities’ rate bases and drive earnings and dividends growth in coming years—yet another reason to expect shares of well-run utilities to generate solid total returns in the second half of 2015 and beyond.

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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