A Heads-Up for Electric Utility Investors

 | Apr 22, 2013 | 3:00 PM EDT  | Comments
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XLU

While skimming the various newspapers this weekend, I ran across two very sobering stories. One was the Barron's headline that 74% of money managers are currently bullish on the stock market. They see earnings strength driving the market higher over the next year, all the way up to their magic numbers on the Dow and S&P 500.

While a mere 74% are bullish for the rest of 2013, 86% are bullish on stocks for the next 12 months. This is the highest reading ever, and it is worth mentioning, in that the previous highs in bullish sentiment eventually led to lower stock prices. It is not a precise timing measurement, but excess sentiment is often a caution flag.

The other reading that caught me off guard was mentioned in a Wall Street Journal column by newsletter and pundit tracker Mark Hulbert. He noted that the Value Line Median Appreciation Potential in the latest issue is down to 50%. This measure is simply the projection of how much the average stock in the Value Line universe will return over the next three to five years. Again, it is not a precise measurement for timing purposes, but lower readings in this measurement have often been a precursor of lower prices.

This of course started my fevered brain searching for additional clues as to how we might profit or, more importantly, avoid catastrophic losses by using this information. I decided to see which stocks are projected to earn three-to-five-year returns that are far less than the averages and are best avoided by investors in a market that looks increasingly toppy.

The first observation from the resulting list of stocks is that if you are invested in a portfolio that is heavy on electric utilities, you need to make some changes now. Virtually every electric utility in the U.S. is on the list of potential underperformers. Most of these stocks have had a great run over the past few years. Yield-seeking investors have bid them up in search of dividends, and these companies' bottom lines have benefited from the low price of natural gas. Over the past three years, the Utilities Select Sector SPDR ETF (XLU) has delivered a solid 14.21% average annual return, but it looks like the party is coming to an end for utility stocks.

The industry faces a lot of headwinds at the current time. One of the biggest is of course the weak economy. Electricity usage is not likely to climb higher when the economy is weak and factories, plants and even office buildings are cutting back on power usage. Conservation is also playing a role in slowing sales, as cost-conscious consumers and businesses look for ways to cut power usage and electric bills.

Interestingly, the low rates that have created demand for utility stocks may also be a contributing factor to falling profits and stock prices. The Federal Energy Regulatory Commission is holding hearings right now on the return on equity earned by the electric companies. There is a growing feeling that the current allowed ROEs are too high in a low-interest-rate environment. This could lead to some adverse rulings that put lower cap on utility profits. Generally speaking, lower profits mean lower stock prices and decrease the chances of a meaningful dividend hike from these companies.

Regulatory and environmental issues will also cost limit gains in these stocks over the next few years. The latest regulations include a restriction in coal-fired plants, and although natural gas has been a cheap source of fuel, it is up quite a bit in the past year. Should natural gas prices move to the upside, the lack of availability of coal as an alternative could hurt the bottom line at many of these companies.

I have done very well with electric utilities over the years by following a very simple strategy. When conventional utilities sell below tangible book value, I buy them and hold them until the sell at about 1.5x book. This usually takes a couple of years, and I collect fat dividends while I hold them. Right now, not one single electric utility stock in the U.S. sells for less than tangible book value. In fact, I cannot find any trading for less than 2x tangible book value. None trade at less than 10x earnings right now either, although on the basis of low economic growth for the next few years, all of them probably should.

The industry has very low growth prospects and historically high valuations. It is time to sell the group and look for cheaper alternatives that have greater potential for dividend increases and appreciation.

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