Even Utility Stocks Have Risks

 | Jul 23, 2012 | 5:30 PM EDT  | Comments
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Stock quotes in this article:

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Utility stocks were once the domain of widows and orphans. Investment decisions were straightforward: Buy a few good utility stocks, live off their dividends and forget about the underlying companies. After all, utilities managed themselves, and dividends were assured.

Those days are over. Over the last several months, three important trends emerged, which changed how investors view and manage their utility stocks. The first trend has been addressed by my Real Money colleague Roger Arnold. In recent articles, Arnold has been warning about falling yields for U.S. Treasury bills, notes and bonds. Yields on bills fell below 1%, to 0.16%, and notes pay only 0.20% for two-year maturities and 1.44% for 10-year maturities. These rates are unprecedented, and they continue to fall.

According to Arnold, yields are much worse in other countries. Incredible as it may seem, countries such as Germany and Switzerland are paying negative yields. Yes, negative yields: Investors must pay to buy sovereign debt.

For those seeking safe incomes, these are difficult times. And while some investors may be unable to move across asset classes, others are looking for safe havens and better yields. Some investors are looking at utilities, such as Pepco Holdings (POM) and Otter Tail (OTTR), which are currently paying over 5%.

These utility investments look attractive until you consider what another Real Money colleague described as the second trend. Tim Melvin has raised two concerns. First, Melvin says that not many stocks qualify as cheap right now. Second, Melvin says that too many investors are searching for higher-yielding stocks, and this has pushed many dividend-paying stocks to the point where the risk-to-reward ratio no longer makes sense to conservative investors. Melvin says "chasing yield is one of the worst mistakes an investor can make."

When it comes to utility stocks, there are good reasons for value investors such as Tim Melvin to be concerned. Price-to-earnings ratios are going through the roof. P/E ratios were supposed to reflect the market's assessment of future values. But for some utilities, price/earnings ratios have become meaningless. Otter Tail is a good example; it's a tiny utility with a crazy price/earnings ratio of 41.

This leads to the third trend: State regulators' growing reluctance to pass along utility costs to consumers. When utilities cannot recover costs, their earnings are jeopardized.

Pepco Holdings is an example. Last Friday, the Washington Post reported that Maryland regulators rejected $50 million of the $68 million increase that Pepco argued was needed.

Duke Energy (DUK) is another example. Duke's management lost credibility, and as a consequence, Duke's regulators may overreach. Duke may face fierce headwinds in Indiana, North Carolina and Florida as it tries to recover cost of operations.

Investors seem to be caught between yield and risk. If they reach for safe utilities such as Consolidated Edison (ED), Southern (SO) and Dominion Resources (D), they're forced to accept high price/earnings ratios to lock in yields. The high price/earnings ratios suggest that investors are exposed to higher risks for their capital.

If Arnold is correct and Treasury yields continue to decline, demand for dividend-paying utility stocks will only increase. As untethered investors move from Treasuries to utilities, price/earnings multiples should increase. If Melvin is right, as multiples increase, the risk to investors' principal will also increase. What's an investor to do?

First, if you aren't doing it already, start reading Arnold and Melvin's columns in Real Money. Watch for their commentary on sovereign yields and utility values.

Second, be careful about how you select income-producing utilities. If a state utility regulator doesn't like a utility, you shouldn't either. For now, stay away from Pepco Holdings and Duke Energy -- they're in asymmetric battle with multiple regulators and multiple states. Other than as speculative plays, there's no reason to own these companies.

Third, avoid utilities with market capitalizations less than $10 billion and utilities with price/earnings ratios greater than 15. Low market caps and high multiples represent greater risks.

Three utilities are sitting in the sweet spot. They are Exelon (EXC), which has a yield of 5.35% and a price/earnings ratio of 12.96; PPL Corporation (PPL), with a yield of 4.96% and a price/earnings ratio of 10.28; and Public Service Enterprise Group (PEG), which has a yield of 4.32% and a price/earnings ratio of 11.58. All three have relatively high yields, low price/earnings ratios, decent market caps, safe payout ratios and diverse assets.

Finally, don't go old school. Don't invest in utility stocks, assume all is well and then ignore the investment. If market caps falter, if the management team becomes subpar or if state regulators overreach, be ready to pull the trigger and exit.

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