Don't Plug Into Utilities Just Yet

 | Aug 10, 2012 | 2:30 PM EDT
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After I discussed unconventional income investing the other day, a friend asked a pretty good question. Why can't income investors today do what our fathers and grandfathers did when they needed income from the stock market? They would just buy some electric utility stocks, maybe some telephone stocks, and sit on them for decades at a time and just collect the dividends along the way.

That worked for literally decades. When I started in this business back in the mid-1980s, much of a new broker's daily activity consisted of pitching utility common and preferred stock to potential investors. Everybody knew these stocks, people were comfortable owning them, and they paid a great income.

As we know, today's utilities are not your father's utility stocks. Deregulation, followed by reregulation in many areas, has changed the industry forever. Utility companies no longer have a tightly controlled monopoly in many areas. They are subject to far stricter regulations. Consumers have a choice in most areas of the country and can opt out of buying power from the local electric company. Utilities are subject to mandates form all levels of government that they invest heavily in alternative energy sources. For electric utility investors, it is a very different world.

In spite of this, as I told my friend, income investors can buy and hold these stocks for a long period of time and collect the dividends for years. The trick is to make sure you buy them when they are out of favor and very, very cheap. I have invested in utility stocks for decades, and I have never lost money buying a utility stock that trades below tangible book value. I have seen money lost chasing yield in the group and buying at high valuations in spite of these stocks' low beta and relative safety compared with speculative stocks.

Back in 2008, I was an enthusiastic buyer of stocks such as Duke Energy (DUK), Pepco Holdings (POM) and Pinnacle West (PNW) when they traded at a discount to their tangible asset value. To say that it worked out well would be an understatement.

I sat down this morning and looked for electric utility stocks that trade below book value. I found that none of them are at a bargain level at the current moment. Investors' hunger for yield has pushed the stocks higher over the past few years. I have been a grateful beneficiary of this activity, but I would caution against buying this sector right now. The sector was up more than 15% last year and now appears overvalued and over-owned.

The industry has some serious headwinds as well. The regulatory authorities have been pushing the industry to move away from coal in favor of cleaner-burning natural gas. Utilities have benefited from this move, as natural-gas prices are very low. Gas has been moving higher this year, and this cost advantage is now shrinking. Companies that still use coal face higher regulatory and cleanup costs over the next few years. No matter what the fuel source, it would seem that U.S. electric companies face higher costs going forward.

There are some other potentially negative issues for utility stocks as we move closer to 2013. If the dividend tax breaks are eliminated at the start of next year, the tax rate on dividends will more than double for many investors. Economic growth remains very weak and could keep demand low well into 2014, so top-line and bottom-line growth will be difficult for many companies to achieve. In addition, electric utility stocks have always been highly correlated with interest rates, and there is not a whole lot of room for rates to go lower from here.

Investors who bought during the massive market decline at bargain valuations have done very well. I suspect that those who chase yield and buy these issues today will have more disappointing results. I would look to prune my holdings of these stocks and refrain from initiating new positions until the market gives you an opportunity to buy them below tangible book value.

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