Sell American Electric Power (AEP)

09/17/2010 12:30 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

There’s certainly something very attractive about a utility stock that pays a 4.6% dividend yield when the 10-year U.S. Treasury is paying just 2.8%. But investors in American Electric Power (AEP) need to realize that if the U.S. economy is speeding up rather than slowing down, they’re bucking investor sentiment by holding utility shares.

Utilities are great income investments when investors are worried about economic growth and are looking for safety. The prices of utility shares, however, tend to fall when investors think the economy is picking up and they start to be willing to take on a little more risk in order to earn, they hope, a lot more reward. At that point in the cycle, utility stocks aren’t attractive on a total return basis.

Utility revenues themselves go up when the economy grows at a faster rate because more economic activity means higher consumption of electricity. But not enough to outweigh the shift in sentiment away from safety and toward risk.

And shares of American Electric Power have another problem. Because the company has been able to cut costs and to successfully negotiate rate increases in many of its markets, the utility has done better than many of its peers in the weak economy. That means the shares have appreciated in price more than those of many other utilities and that has lowered the stock’s yield in comparison to its peers. Although a 4.6% dividend yield sounds hefty, the average utility yields 4.9% right now, according to Standard & Poor’s.

I think the shares have a limited upside—S&P has a 12-month price target of just $39 for a stock now trading at $36 a share—if sentiment doesn’t turn too strongly toward more risk and away from safety. If the economy does strengthen enough so that investors feel a little better about economic growth, I think the shares could actually fall in price.

I just don’t see this stock attractive at this point in the economic cycle on a total return basis

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