Pros and Cons of Utilities

07/23/2014 10:00 am EST

Focus: STOCKS

Jeffrey Kosnett

Senior Editor, Kiplinger's Personal Finance

Despite sector headwinds—some valid and some unwarranted—Jeff Kosnett of Kiplinger’s Personal Finance believes select utilities remain a solid option for conservative investors seeking moderate growth and growing income.

Steven Halpern:  Our guest today is Jeff Kosnett of Kiplinger’s Personal Finance.  How are you doing today, Jeff?

Jeff Kosnett:  I’m doing just fine.  How are you?

Steven Halpern:  Very good.  Well, our topic today is utility stocks and the Dow Jones utility average has sharply outperformed the industrials so far this year.  What accounts for the outperformance?

Jeff Kosnett:  Two things; one is that interest rates have continued to go down or to stay low and many people believe that the primary reason for investing in utility stocks is as a substitute for or a supplement to bonds, which, obviously, are doing well; that’s one reason. 

The other reason is that utilities have been badly misunderstood and often overlooked and those investors who have been in search of a good source of quality dividends as well as not having to overpay have found utilities to be attractive on both price and yield.

Steven Halpern:  Now there are skeptics who see headwinds facing the sector and one argument they make is that over the long term, solar power will hit traditional electric utility operations, but you consider that argument to be wrong-headed.  Could you explain?

Jeff Kosnett:  Well, one reason is that the utilities themselves are oftentimes heavily involved in solar power.  They own the transmission lines, they have built enormous solar projects of their own, so that some of the power that’s being generated—and especially in large scale projects—is controlled by the same utility companies. 

Southern Company (SO) is a good example.  Go to their Web site and see what they’ve been up to, so it’s not strictly a case where every homeowner can put some solar panels on their roof and kiss the utility company good-bye. 

I also would add the logic that television didn’t kill the movies and the Internet hasn’t killed everything else and there’s a lot less urgency to than this, so it’s easy to argue.

Steven Halpern:  So, in addition to this misunderstanding about solar, you note that there are some additional flawed arguments against the power companies.  Could you expand on that?

Jeff Kosnett:  Wall Street has never liked power companies.  I’m not really quite sure why.  They’ve held them to a different standard than so many other stock groups.  They start out with the idea that it’s almost like you should justify owning these things at all, that so many problems have happened in the past. 

There was this period—which is now a distant memory—when some of the electric companies decided to get involved in too many trading kind of games—Enron being the big example, but not just not them—trying to buy and sell power, trying to be more of a third party and an intermediary rather than a producer and generator of energy. 

You have the issue where there have been strong performers and weak performers, so there have been a lot of merger and acquisition activity in this industry, and so therefore, the investor and companies that are left now tend to be bigger and stronger and better financed, whereas in the past there were many that were not. 

There have been instances where I think there has been a lot of misunderstanding of how the regulators act.  Their job is not to try to enforce extremely unprofitable operations by the utility companies; they just want to make sure that the service is reliable, and then that’s been misunderstood.

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Also some of the investment areas that these utilities sort of compete with for yield such as real estate investment trusts, master limited partnerships, and municipal bonds have performed so well that they utilities presented themselves lately as kind of a bargain, so all that played out last year in some weak performance and it explains the excellent results so far in 2014.

Steven Halpern:  Now, do you see any valid concerns regarding this sector in areas that investors need to be aware of before they invest too heavily in the sector?

Jeff Kosnett:  Well, I wouldn’t say anybody should invest too heavily.  There are all the usual concerns that, when you start seeing a stock group have a big year that the next year may be, you know, not so big.  I would also caution against a little bit of over exuberance here in thinking that these are growth stocks. 

They’re not; they’re income stocks with a growth kicker, and the growth kicker depends on the performance of the economy, and the economy this year has been pretty decent.  Most of the people in America still think we’re having a recession or something like that.  We’re actually on the verge of 3% growth. 

Another thing to note with utilities is that some of them have a lot of debt and some of them have had problems with, sort of, event risk.  Hurricane Sandy being a good example, causing Consolidated Edison to have to spend about $2 billion to fix it up and strengthen it’s, basically, what we’ll call its defenses against further storms. 

The regulatory climate in some states is different than others, but generally speaking, these costs get shared among the stockholders, the general public, and the creditors, so the big thing to be aware of is that you’re talking here about moderate total return stocks with reliable dividends.  You’re not talking about some honking bull market here that’s going to go on for a long time.

Steven Halpern:  So, for those looking to invest in the sector, in your recent article in Kiplinger’s Personal Finance, you highlight three distinct approaches, and first, you point to a fund that gives exposure to the broad spectrum of the industry.  Could you tell us about that?

Jeff Kosnett:  Yes, if you do that with something like a Fidelity Utilities (FSUTX) or a Vanguard Utilities (VPU), you get the no-brainer broad brush exposure to the largest and most liquid names in the industry.

And then what you’re saying is essentially, “I want 5%, or I want 7%, or I want 10% of my money in this sector, and I want to do it in the most simple and cost-efficient way possible, and that’s how to do it.” So that’s where we take on the idea of using a mutual fund.

Steven Halpern:  Now, you also note that investors could look towards more actively managed mutual funds.  What’s the advantage there?

Jeff Kosnett:  Well, as I’ve observed over the years with rather narrow sector type funds, and not just in stocks, but also in bonds, for example, in junk bonds, it’s the same way. 

The small number of investment managers who have made a lifetime out of following just one field tend to know one heck of a lot about it.

There’s a real experience premium here when you have a manager like the fellow John Kohli—from Franklin Utilities (FKUTX)—who is probably the most encyclopedic fund manager about utilities there is, and he managed the fund for yield, and secondarily, for total return. 

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He manages his traditional utilities fund, so you can be confident that if you use an actively managed fund, you should have somebody who really knows something about utilities. 

There aren’t many of them, and some of them have sales loads, and also what happened was that some utility funds—back when the industry was struggling about ten years ago—sort of reinvented themselves as general income funds so that they could broaden their holdings outside of just utilities, because 100% utilities in the industry’s bad times is not a winning formula, so there aren’t that many funds that are just quote, “utility funds.”

And I must add that the definition of a utility has to be pretty specific.  A coal mine is not a utility.  A real estate investment trust that leases storage space to telecommunications companies is not a utility. 

A utility, to me, is a company that sells electricity, or telephone service, or water, or sanitation, or some other essential service that you require to live and is pretty much guaranteed a fair return on its investment, so the definition of a utility is—can be fluid.

Steven Halpern:  Now, finally for those seeking to invest directly in the individual utility stocks, you offer some favorites in your recent article.  Would you share some of these ideas?

Jeff Kosnett:  Well, I did mention in this article, American Electric Power (AEP), which has basically been kind of the archetypal regulated power industry giant, doesn’t do anything stupid, invests in the industry in about ten or 11 or 12 states and has had a good record. 

National Grid (NGG), which is a British company, has operations in both the United States, which would be in New York state and New England, and in the UK where electricity generation is quite profitable. 

I mentioned Xcel Energy (XEL) out of Minnesota, but I wouldn’t limit the list to only three.  If you’re going to buy individual stocks, I would buy six, or eight, or ten, and I wouldn’t really go into it thinking that there’s only a small number that are worth owning.  Just look for the good dividend record, a yield of 3.5% to 4% or even 5%, and a service area where the economy is pretty good. 

One of the risks, of course, would be that if you invest in an electric company in an area where the economy goes into a tailspin, then there will be less generation and less demand for the services, and also then, you might get politicians saying hey, you know we got a lot of unemployment around here, how can you raise the rates, so those investments are all good. 

There is one unusual situation is a company Exelon (EXC).  It’s been much more volatile than the rest of the sector. It went way down, now it’s way up. 

I don’t know what to make of it, so I’m neutral on it, but people sometimes manage to catch that one as depressed and make a little bit of a trading profit, but I think the dividend yield doesn’t measure up to the rest.

Steven Halpern:  Well, we appreciate you taking the time today.  Thank you for sharing your insights.

Jeff Kosnett:  Sure, thank you.

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