If you want to invest in electric utility fund, find out what its strategy is

MUTUAL FUNDS

October 23, 1994|By New York Times News Service

Electric utility stocks have tanked 20 percent or more only seven times in the last 50 years, but 1994 has been one of them.

Investors can blame higher interest rates. And if history is any measure, rising rates may weigh in for awhile: although two of the declines did end within a year, the average length of the previous collapses was 17 1/2 months and the average drop was nearly 30 percent.

But if you want to play a utility fund, know its strategy: Does it go for high yield, or concentrate more on high-quality utilities better placed to withstand new competition?

Mark Luftig, who covers the industry for Kemper Securities in Chicago -- and was designated the top electric utilities analyst last year in one survey, with a 24 percent return on his picks -- is recommending 10 quality issues for their long-term outlook.

They "fit a defensive profile for utility investors," he said.

The prices of the Kemper 10 -- Dominion Resources, Duke Power, FPL Group, New England Electric System, Pacificorp, the Southern Co., Teco Energy, Western Resources, Wisconsin Energy and WPS Resources -- have been tarred by the declines in weaker utilities. But the 10 are popular with a number of mutual fund managers because they are poised to retake the field when rates stop advancing.

These companies, said John E. Lennon, manager of the $1.15 billion Colonial Utilities Fund, "are financially strong, with reasonable payout ratios and low costs."

Morningstar Inc., the mutual fund research company based in Chicago, matched Luftig's picks against its data base of utility funds and identified funds with big concentrations of these companies. The managers' rationale is the same: The stocks have strong balance sheets, the earnings power to increase dividends annually for the foreseeable future, low cost structures and excellent credit ratings.

As low-cost providers, they are also considered likely winners in the new competition expected as a result of the National Energy Policy Act of 1992. Subject to approval by state regulators, electric utilities will be able to sell their power directly to users over their rivals' transmission lines.

Almost exactly like bond prices, utility stock prices vary inversely with interest rates because they are purchased primarily for their yield. A Kemper index of 80 utilities showed a decline of 24.1 percent between Sept. 13, 1993, and Sept. 30, 1994; of that total, 22.6 points were attributable to higher rates.

With the exception of New England Electric, whose current payout is around 7.5 percent, the Kemper 10 have dividend payouts well below the industry average of 7.2 percent. Duke's is a mere 5 percent.

Until now, that has been a major minus for funds that invest heavily in the companies; those funds are among the worst-performing in their group. In total returns, all were down by double digits in the year ended Oct. 14, except for Franklin Global Utilities, whose foreign forays helped it almost break even.

The managers are betting, however, that the stocks will produce above-average total returns -- capital appreciation plus dividend growth -- in part because of their conservative payout.

"The most vulnerable utilities are the ones paying out 90 percent to 100 percent of their earnings in dividends," said Edwin W. Bragdon, manager of the $527 million EV Traditional Total Return Trust. "We have stressed those paying out less than 80 percent; that makes the dividend safer and the company more flexible."

Flexibility includes diversifying into businesses whose profits are not regulated. Teco Energy, for example, produces coal and has transportation operations.

Kemper's 10 are so good, said Jack S. Levande, manager of the $1.8 billion Smith Barney Shearson Utilities Fund, that he would own more of them -- except he would then be hard-pressed to maintain the fund's dividend, currently 6.1 percent.

The $2.8 billion Franklin Utilities Fund owns a bigger concentration of the 10 than any other fund in Morningstar's data base -- more than 22 percent of its assets, with 7 of the Kemper 10 choices.

Sally Edwards Haff, a co-manager of this fund and Franklin Global Utilities, said she believes the stocks have far more room to advance than decline. But even if share prices do not move up in the next 12 months, she said, the combination of current yield and anticipated dividend growth could produce average returns of 9.3 percent.

The $1.1 billion Putnam Utilities Growth and Income Fund is down less than 7 percent this year, in part because its manager, Sheldon Simon, eschewed electrics for telephone companies, gas companies and non-utilities.

He said he now believes rates are unlikely to go significantly higher, so he may return to electrics over the next 12 to 18 months.

At the same time, he does not rate the Kemper 10 as bargains, but he said: "If you were looking to buy electric utilities and you wanted to have peace of mind with the fundamentals, these are the companies you would look to own."

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