Utility stocks send off heat

Anxiety over market transforms them into a sound defensive play

S&P's sector index is up 9%

Your Money

October 31, 2004|By Andrew Leckey

The presidential election, no matter whether George W. Bush or John Kerry comes out on top, means one less thing for Americans to worry about.

They then can take a deep breath, relax and get back to fretting about other concerns, such as oil prices, the economy and terrorism.

Anxiety has transformed utility stocks into a hot investment in 2004. Now I don't mean "hot" in the way that unregulated power and gas trader Enron was hot in its day. I mean hot as in a defensive investment performing well.

The Standard & Poor's utilities index is up 9 percent this year vs. a 1.5 percent decline for the S&P 500. Utilities also provide an average dividend yield of 3.7 percent compared with 1.8 percent for S&P 500 stocks.

Interest rates and inflation remain low, benefiting utilities that carry a lot of debt. This also makes the total returns of dividend-paying utility stocks more competitive with low-yield bonds.

Renewed optimism, however, could alter this scenario. A more positive mental attitude just might cause upbeat investors to shift money from defensive utilities into aggressive stock groups, such as technology, whose prices have declined.

Mild weather in portions of the country this summer was a negative for utilities because it cut down on air-conditioning use. But the devastating hurricanes that hit the Southeast, cutting off electricity to millions and hurting third-quarter earnings of utilities in that region, haven't had a significant impact on the overall industry.

There are lingering issues from the California energy crisis of 2000-2001, such as lawsuits against Sempra Energy's San Diego Gas & Electric and Southern California Gas. There may be a trial early next year in an antitrust lawsuit in which the city and county of Los Angeles and other municipalities seek damages of up to $27 billion.

The suit alleges the utilities conspired with El Paso Corp. to prevent competition from cheaper and more plentiful Canadian supplies of natural gas. El Paso in December agreed to pay $1.7 billion to settle the charges and is no longer part of the lawsuit.

"Utilities are almost always good defensive plays, and I would say that near term the stock market continues to be defensive," said Douglas Fischer, senior electric utility analyst for A.G. Edwards & Sons in St. Louis, who expects that any outflow of assets would be moderate. "That augurs well for these stocks, even though the economy is still reasonably healthy and should be improving."

Most analysts believe utility stocks continue to sell at a significant discount to their fair value, providing an opportunity for further price increases.

"Utilities stocks historically do well in the third year of a bull market about 75 percent of the time, and we celebrated that anniversary on Oct. 8," observed Sam Stovall, senior investment strategist with Standard & Poor's in New York. "They perform best in challenging periods."

Since the bulk of utilities are regulated, they deliver relatively stable earnings and high dividends.

"Utilities are for investors who have trouble with the volatility we've seen in stocks this year and want a smoother ride," said Robert Strauss, portfolio manager with the $61 million Icon Telecommunications Fund (ICTUX) in Denver, up 15 percent over the past 12 months. "Though utilities won't be the leader, we do expect them to be participating in a broad stock market rally over the next six to 12 months."

The industry is ever changing. For example, the Federal Communications Commission recently changed its rules to encourage development of a new technology that provides access to high-speed broadband services using the nation's power grid. That means electric utilities may be competing to offer Internet access through electrical outlets.

"Utilities were a widows-and-orphans type of investment, where you could put money away safely, but since deregulation you really need to look on a stock-by-stock basis at what individual companies are actually doing," said Mark Sadeghian, utilities analyst with Morningstar Inc. in Chicago. "For example, Dynegy Inc. sold off its regulated utility Illinois Power and is now unregulated, while a utility such as NStar is almost entirely regulated."

American Electric Power Co. (AEP), with a huge portfolio of low-cost generation that includes coal-fired plants, is a stock recommended by Sadeghian and Stovall.

Constellation Energy Group Inc. (CEG), a gas and electric company operating in central Maryland that is trading at a discount with good upside potential, is a favorite of Stovall and Strauss.

Fischer recommends Cinergy Corp. (CIN), a Cincinnati utility with holdings in Ohio, Kentucky and Indiana; Xcel Energy Inc. (XEL), provider of service to electric and natural gas customers in 11 states; and SCANA Corp. (SCG), which has 12 subsidiaries in the Carolinas.

He also likes FPL Group Inc. (FPL), whose holdings include Florida Power & Light Co. and FPL FiberNet; TXU Corp. (TXU), a provider of electricity and natural gas in the United States and Australia, and Dominion Resources Inc. (D), which manages power generation in eight states.

Other Sadeghian favorites are NStar (NST), a low-risk company with 95 percent of its transmission and distribution in regulated businesses, and Endesa SA (ELE), a Spanish utility that has a solid core operation and strong dividend yield.

Finally, China's Huaneng Power International Inc. (HNP) is recommended by Stovall.

Andrew Leckey is a Tribune Media Services columnist.

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