Waiting for the Overreaction
08/20/2013 11:00 am EST
Yield hunters may be writing off utility stocks ahead of the Federal Reserve tapering. But worth a look are utilities in a position to raise dividends. Here's one, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
Today let's talk dividends. Specifically, dividend-paying utility stocks.
How do you tell if a stock in this beaten-down sector yields enough to make it a buy in the current, risky market?
The looming possibility that the Federal Reserve will start to taper off its $85 billion in monthly purchases of Treasurys and mortgage-backed securities has sent global financial markets into a tizzy of guessing.
Suddenly, income investors who have been longing for anything paying more than 2% are confronted with 10-year Treasurys paying 2.8% and dividend stocks with yields of 4%, 5%, or more.
The problem, though, is figuring out whether those yields are worth the risk.
Prices of bonds and dividend-paying stocks have plunged. They could keep falling. What look like fat dividend yields might not be adequate compensation for the risk of losses to capital.
And maybe yields tomorrow will be even higher.
Frankly, we're all guessing here. What I'm sure of is that all this guessing will produce overreaction and mispricing. And that I'd like to be ready to pounce when the inevitable overreaction produces attractive mispricing.
But I've also started to see scattered examples of dividend-paying stocks, even in the battered utility sector, where current yields look like an adequate return for likely risks to capital.
I argued recently that you want to make sure you have cash on the sidelines ready to put to work if September and October produce some bargains. Today I'll point you to specific stocks in parts of the market where I think current yields are a good value.
I'll be laying out what you should be searching for in utility stocks if you're trying to find a high yield. Next week, my focus will be MLPs (master limited partnerships) and REITs (real estate investment trusts.)
But, first, let me explain why guessing is likely to produce bargains in the financial markets. I'd break guessing down into two parts.
First, there's the guessing of what's it worth in asset classes clearly connected to the Federal Reserve's program of asset purchases. And second is the guess as to what's connected. If the Fed does start to taper off its purchases, how will that affect seemingly unrelated assets, such as Brazilian stocks.
Today and next week I'll focus on the first kind of guessing. It makes sense that if the Fed scales back its purchases of Treasurys and mortgage-backed paper, yields on these assets will climb. And with Treasurys serving as the benchmark for so much of the income sector, it makes sense that yields will rise across much of the financial market, and prices of these assets will fall.
The guessing here, involves estimating the effects of a Federal Reserve taper that is, so far, unspecified in its schedule and dimension.
The 10-year US Treasury closed at a yield of 2.85% on August 16. A month ago the yield was 2.53%. A year ago it stood at just 1.81%.|pagebreak|
Of course, where the yield is headed depends on way more than just the pace of any Federal Reserve taper. The yield on the 10-year Treasury note in August 2014 also depends on the inflation rate, the strength of the dollar, the availability of attractive alternatives, growth in the US economy, and on the level of fear in the financial markets—to name a few factors.
Not to belabor the obvious, but no one knows for sure what any of those other factors will look like. (Just as we don't know, more immediately, if we'll see a government shutdown over the budget and the debt ceiling at the end of September.)
But the inability to know has a powerful effect. With yields already so low and the specifics of the Federal Reserve's tapering unknown—but apparently set to begin soon, selling strikes, many income investors see as the best policy. In June, for example, overseas investors sold US Treasurys at the fastest pace on record. Foreign investors (mostly in China and Japan) sold $40.8 billion in Treasurys in the month, according to the US Treasury.
Utility stocks, as an income vehicle with Treasury-like qualities and clearly at risk from any Fed taper, have been hit hard on the increasing worries of a September or October move by the US central bank. The iShares Dow Jones US Utilities (IDU) exchange-traded fund is down 4.1% in the last month. Some individual utility stocks have been hit even harder, especially recently. Duke Energy (DUK), the largest regulated utility in the United States, declined 4.2% in the week ended August 16. Southern (SO) declined 5.2% in the month through August 16, and lost 7.4% over the last three months.
That pummeling on price has driven dividend yields on utility stocks to what, initially, look like very attractive levels. Duke Energy now shows a dividend yield on 4.7%; the dividend yield for Southern is 4.8%.
The question for utility stocks, as for Treasurys and other income vehicles, is are those yields enough? Are they attractively high now, or due to get yet higher, as the Fed taper begins? And would any dividend payout be more than wiped out by a tumbling stock price, as interest rates rose after the Fed began reducing its asset purchases?
So many uncertainties. So much to guess at. You can understand why utility stocks, like Treasurys, have headed lower: There's not much in this situation to encourage anyone to buy.
Unfortunately, I don't have any magic solution for resolving these uncertainties. I suspect that the Fed's reduction in asset purchases will be very slow and the effects less damaging than the markets now reflect. But that's only a suspicion, and I'm very reluctant to advise a course of action based on a suspicion or hunch.
Fortunately, I think there is a way to approach the uncertainty that the Fed has introduced into the income markets. It doesn't yield a big picture call on any sector, but it does give investors a way to find individually good stocks in this environment.|pagebreak|
The key to this process is to find income vehicles that are different from Treasurys in one critical way; that is, they have a way to increase cash flow, and thus, the money available for dividends over time. Treasurys and other bonds don't, and that's why they're called fixed income assets. They have a fixed call on the underlying cash flow and the cash that they pay out doesn't increase over time.
The higher the potential for dividend increases, the more likely that a utility's stock price will hold up in the current environment, and the more likely, that a current high yield is a bargain that you ought to take seriously.
There's no magic formula for finding these stocks, just old-fashioned block-and-tackle fundamental research that focuses on the details of a utility's business and its cash flows.
Let me dig down on two utility stocks to give you an idea of what I think you should look for in the current environment.
First, in the looks-too-much-like-a-Treasury-bond category, is Duke Energy.
About 85% of 2010 EBIT (earnings before interest and taxes) came from Duke's regulated businesses. In that part of the business, state regulators rule on requests for rate increases, submitted by the company, after looking at the company's growth in assets and deciding how much of a return on equity the company should earn. That makes the regulated utility business into one where the utility spends to build new assets, so that it can add them to its rate base and earn the allowed return. Duke's capital spending program amounts to about $18.7 billion in 2013-2016.
That makes Duke's basic business a play on the spread between what the market charges for the money it borrows to build new assets and the return that regulators allow.
Duke Energy finished 2012 with $36.4 billion in long-term debt (up from $18.7 billion at the end of 2011), and $4.2 billion in short-term debt (up from $2.3 billion at the end of 2011.) As you might imagine, that results in a hefty interest bill at Duke—$1.5 billion for the trailing 12 months. That's up from $1.2 billion for 2012 and $859 million in 2011.
It's this basic business model, which Duke Energy shares with most utilities, that makes the company's stock so exposed to worries about climbing interest rates that might result from a Federal Reserve taper. Higher interest rates would add to the company's bill for its current debt, and make that $18.7 billion in proposed capital spending, less profitable for the company.
For the next stage in your analysis, you need to see if there are any significant wrinkles to this model at an individual companies. For example, Duke Energy acquired Progress Energy, another utility. The company has projected synergies of $600 million to $800 million from combining the operations. That's clearly a potential boost to Duke's earnings. Unfortunately for shareholders, Duke has promised regulators that the bulk of those savings will be passed through to its customers. Very little, if any, of those synergies will get passed along in the form of higher dividends.|pagebreak|
What you've got with Duke Energy is pretty much a plain vanilla regulated utility—one with a history of solid management—where the business model is very exposed to higher interest rates. So yes, the 4.7% dividend yield is attractively high (especially because there's little doubt that the company will be able to maintain it). But, to me, the yield isn't high enough to offset Duke's exposure to any Fed taper.
Contrast this to TECO Energy (TE), another regulated utility, but one where the business model has lots of potential wrinkles.
TECO's biggest business unit is Florida's Tampa Electric. That's a good business for a regulated utility now because, with the recovery in Florida's economy, Tampa Electric's customer base is forecast to grow by about 1.2% to 1.4% in 2013. And Florida's utility regulators have historically been some of the most generous in the country. In its last rate increase request, Tampa Electric received approval for an 11.25% return on equity.
But TECO piles lots and lots of wrinkles on that basic business model. The company is in the midst of a restructuring that looks to sell non-core assets and to reinvest in the core regulated business. So far, that has resulted in the sale of TECO's operations in Guatemala and the pending purchase of New Mexico Gas with its 500,000 regulated gas customers for $950 million.
The big question for TECO—and for investors—is what will happen over the next year to TECO Coal, the company's big non-core asset. Historically the coal business has provided about 20% of the company's operating earnings, but that hasn't been the case recently, as falling coal prices and volumes have blasted the coal-mining sector. In the second quarter, TECO Coal reported operating earnings of just $700,000 versus $12 million for the second quarter of 2012. TECO Energy has said that it is looking to sell the coal business—if it can get an attractive price. That would seem unlikely in the current market, except that in November 2011, TECO Coal announced the addition of 65 million tons of metallurgical coal to the proved reserves at its Appalachian mines. Metallurgical coal is clearly the most attractive part of the coal market and it's likely to recover more quickly than thermal coal with growth in the global economy.
With TECO Energy, I think you're looking at a high 5.3% dividend yield that isn't likely to increase significantly in 2013 or 2014. Payment ratio for 2013 is a high 92% and I don't think management will go any higher. (Nor should it.) But the key issue for TECO Energy is when/if it will sell its coal business. A sale of that asset, which would remove a drag on earnings, and give the company cash to reinvest in its regulated business, would result in a resumption of dividend growth. When might investors expect a sale and when could then expect dividend growth? Those questions hang over the stock and are the likely driver for any change in share price. Which, paradoxically, gives TECO Energy shares some protection from worries about higher interest rates in a Fed taper.
If, for Duke, and its regulated utility business, the macro question of interest rates is likely to drive the share price in the short- and mid-term, for TECO Energy, the wrinkles to the business model—when will the company sell its coal unit—is the key driver. To me, that argues that the 5.3% yield at TECO Energy is a better bargain in this interest rate environment than the 4.7% yield at Duke Energy.
I'm adding shares of TECO Energy to my Dividend Income portfolio today.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund's portfolio here.