SECTOR INVESTING

Utility stocks—a powerful choice

They're no longer the sleepers in your grandfather's portfolio. Deregulation and a spate of mergers and acquisitions have awakened the sector, increasing the potential for profit and loss.

By Susan Harrington Preston

Since California's deregulation pratfall, utility stocks have acted less like tortoises racing snails than like runners in a three-legged race: They tend to fall flat in public and embarrassing ways—as did Pacific Gas and Electric and Southern California Edison, two California utilities that filed for bankruptcy in 2001.

Utility stocks are a whole new investment game. For decades, they were all but synonymous with value stocks, and a foundation of low-risk, snoozer portfolios. They even stood in for bonds for softening portfolio risk: Utilities borrow a lot of money for short-term energy purchases, so their prices, like those of bonds, rose when interest rates fell and fell when interest rates rose.

When deregulation leaped into this quiet backwater, it made waves of price volatility wild enough to churn the stomachs of the risk-averse investors who typically favor utility stocks. The Dow Jones utility index plunged late in 1999, rose steeply in January 2000, then dived in March. It climbed over time and crested in December 2000, only to plummet again in January 2001. Those who bought into the index before mid-2000 made money; those who bought at the December 2000 peak lost it (not counting dividends).

Deregulation also dissolved the lines that once separated utilities—that is, state-regulated retailers and distributors of power—from energy companies, which extract, process, and ship fuel to power plants. Traditionally, the nation's electric utilities had handled power from plant to plug, and they owned both the wires and poles that distributed power and the power plants that made it. Under deregulation, some states decided to break these local minimonopolies by demanding that the utilities split off their power plants.

"The typical scenario is that utilities issued two stocks, one for the retail operations and another for the power-plant arm," says Jay Evans, who runs Fleet Financial's Boston-based Galaxy II Utility Index Fund­Retail Shares, included in our list of top funds. From there, the parts took off in different directions. The utility (the retail arm) remained regulated and posted sluggish earnings, while the unregulated power-plant arm entered a new stage of growth. Add big energy firms to the mix, and you've got today's fast-moving power industry, in which all three kinds of companies are regrouping, resplitting, and regrouping again, in a merger-and-acquisition trend that's far from over.

So what should you do in this new era for power portfolios? Drop your utility holdings and run? Buy into big, diversified energy firms that generate power and sell it to utilities? Turn to utility mutual funds? We'll help you decide.

Utilities retain some traditional charms

Utility (retail power) stocks still perform much as they did a dozen years ago, but in John Kohli's eyes, they offer better growth potential than ever. "Wall Street's prediction of earnings growth is actually stronger for the electric companies than for the S&P 500—8 vs 6 percent annually over the next five years," says Kohli, one of three managers of the Franklin Templeton Secuities' Franklin Utilities Series fund in Foster City, CA. "So you're getting better earning prospects out of this sector."

Moreover, utility stocks still tend to be undervalued. "They're trading at 13 times 2001 expected earnings," explains Kohli. "The S&P 500 trades at 23 times expected earnings."

Utility stocks are still income producers, too. Dow Jones Utility Index stocks pay an average of 3.6 percent of their sale price in dividends, compared with 1.3 percent for the Standard & Poor's 500 Stock Index. Some yields are exceptionally high: Ameren of St. Louis, for instance, pays $2.54 a share—more than 6 percent of the share price.

If you plan to buy individual stocks, take a cue from California's experience: Look for companies with reliable sources of reasonably priced power. The culprit in last year's bankruptcies was a power-supply squeeze that forced the utilities to pay high, deregulated prices for wholesale power at a time when they could charge only low, regulated prices for retail power. The utilities on our list of a dozen top power-portfolio stocks are unlikely to suffer a similar fate.

Utilities that are good investment picks often own power plants. That's the case with several of the stocks Judith Saryan recommends. Saryan, who manages the Boston-based Eaton Vance Utilities Fund, favors Exelon—also a key holding in John Kohli's Franklin Utilities Series fund.

"Exelon is a combination of PECO Energy and Unicom, which merged not long ago," says Saryan. "PECO was kind of a sleepy utility, but several years back it invested in nuclear power plants as they were sold off by companies that went through deregulation. PECO bought nuclear plants for pennies on the dollar, so it can earn good returns. That was a great strategy." Entergy and Dominion Resources are doing the same thing, and Saryan likes Dominion in particular because of its holdings in natural gas, which is also in short supply nationwide. "Dominion bought a pipeline company, and it has exploration and production activities," she says. "NiSource is very attractive, too," she adds. "It's also heavily natural-gas-oriented."

Go for the growth stocks

In today's tight power market, selling fuel wholesale is like pumping money. Although a shortage of power-plant capacity may be a bane for utilities, it's a boon for energy firms, many of which have added power plants since deregulation began.

As a consequence, energy firms have replaced high-tech companies in the role of growth stocks in many fund managers' portfolios. Companies such as Calpine, AES, and Dynegy, which focus on power generation, appreciated rapidly during the past few years.

Indeed, these power-generating companies are among the top 10 holdings of several of the country's most successful aggressive-growth mutual funds. Quaker Aggressive Growth Fund, which has one of the highest three-year returns among aggressive growth funds, had a whopping 32 percent of its stock holdings in the energy sector.

Kohli notes that some utilities have even sold off power plants to take advantage of the plants' high purchase prices. "The growth companies, the power-generating companies, are selling at 25 to 30 times expected earnings," he says. You can split the difference between fast-growth power plants and slow-growth utilities by buying into large firms that combine both in a single entity. Unlike electric or gas utilities, which tend to be small and regional, these companies are nationwide or global. A dozen or so of these giant firms provide most of the nation's power, which they can sell and send just about anywhere wires go.

The nation's foremost generator of electricity is American Electric Power of Columbus, OH, but generation is only one of the big firms' activities. Houston-based Enron, which cites wholesale services—mostly energy deal making—as its biggest moneymaker, takes in more than seven times as much in revenues as American Electric Power: $101 billion in 2000, vs American Electric Power's $13.7 billion.

These firms are volatile. Enron shares went from 35 in late 1999 to 90 nine months later; it had dropped to 45 by July 2001. Shares of American Electric Power went from 27 in March 2000 to 51 in May 2001 and had fallen to 42 by July. However, to aggressive-growth mutual-fund managers—and some daring individual in-vestors—volatility in the pursuit of gains is no vice.

The author is a former Senior Editor of Medical Economics.

Top utility mutual funds

A dozen choice utility stocks

*Pays no dividends. All stocks trade on New York Stock Exchange. All figures through July 23. Sources: Quicken.com, companies

 

Sue Preston. Utility stocks--a powerful choice. Medical Economics 2001;16:47.