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Get Four
|  | OCTOBER 12, 2004
 FUND INVESTOR By Palash Ghosh A Powerful Spurt by Utility Funds The usually staid sector has outpaced the broader market in the past year. Chances of that continuing, however, aren't too good Utility funds, often ignored by adventurous investors seeking more aggressive returns, have recently outperformed the broader equity market. For the 12-month period through Sept. 24, the average utility fund soared 20.6%, while the Standard & Poor's 500-stock index gained 13.3%. Longer term, however, utility returns have been less than stellar. For the three-year period, the average utility portfolio was roughly flat, rising 0.7% annualized, vs. 6.5% for the S&P 500. Over the five-year period, utility funds rose 1%, vs. a drop of 1.3% for the index. SHELTER FROM THE STORM. Defensive, conservative investors like utility stocks because they provide stable, albeit modest, returns and above-average yields. Indeed, the sector has welcomed many investors seeking a refuge from markets buffeted by geopolitical tensions, record high crude-oil prices, rising interest rates, and sluggish economic growth, among other concerns. Chris Ingle, an analyst for the INVESCO Utilities Fund/A (IAUTX ; the fund will change its name to AIM Utilities Fund on Oct. 15), points out that while sector rotation has propped up utilities, improving company fundamentals, healthier balance sheets, increasing free-cash-flow generation, a more favorable regulatory climate, and rising dividends have also drawn investor interest to the shares. Two of the best-performing utility funds over the longer term -- Franklin Custodian Funds: Utilities Series/Adv (FRUAX ) and Eaton Vance Utilities/A (EVTMX ) -- have somewhat different investment approaches. Portfolio manager Judith Saryan had about 26% of the Eaton Vance fund's assets in telecommunication services as of June 30, including such names as Verizon (VZ ) and SBC (SBC ). About 56% of her assets were in utilities. RATE HEADWINDS? John Kohli, the manager of Franklin Utilities, is more purely concentrated in utilities, with 76% of his assets in electric utilities, 16.2% in gas distribution, and 3.5% in water companies as of Aug. 3. His top holdings include FirstEnergy (FE ), Entergy (ETR ), Dominion Resources (D ), and FPL Group (FPL ). Both portfolios are ranked 5 Stars by S&P. Despite the group's recent outperformance, utility stocks are facing some headwinds, namely the Federal Reserve's commitment to tightening credit. "Higher interest costs do have a negative impact on profitability," Ingle says. "Moreover, higher interest rates tend to make high dividend-paying stocks, like utilities, less attractive relative to bonds. Broadly speaking, increasing rates tend to drive utility-stock prices down." Indeed, utility stocks have fallen an average of 10% six months after the Federal Reserve began rate-tightening programs since 1970, according to Sam Stovall, S&P's chief investment strategist. His research also indicates that utility issues climbed an average 6% six months prior to the start of these rate hikes. CAUTIOUS. Ingle is responding to the rising rate environment by keeping core holdings in high dividend-paying utilities, while also uncovering certain lower-yielding companies that are undergoing successful turnarounds. He cited TXU (TXU ) as an attractive utility restructuring play. "New management at TXU is executing a successful turnaround," he noted. "TXU has been our best performer this year, with the stock price doubling since the beginning of 2004." Although record high oil prices are a grave concern for most stock-pickers, they don't significantly affect utility stocks. "Electricity generators that use oil price-linked fuel sources will experience higher costs," Ingle explains. "However, oil is not a large component of the fuel mix in most regions. Regulated utilities typically pass through fuel cost changes to their ratepayers, albeit with a regulatory time lag." Looking ahead, however, Ingle is a bit cautious. "The utility sector is returning to its historical risk-return profile," he says. "Many of the troubled companies of 2001-02 have made significant restructuring progress since then. My outlook for 2005 is for moderate earnings growth with sustainable dividend increases." Here are the best-performing funds in this category over three different time frames:
 Ghosh is a reporter for Standard & Poor's Fund Advisor All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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