Utility Funds Feel the Power


By Palash R. Ghosh Utility stocks have been as hot as this summer's weather. Now that President Bush has signed into law the massive multibillion-dollar Energy Policy Act of 2005, utility stocks and mutual funds that own them should receive more attention.

But given the current climate of rising interest rates and price gains already recorded, should investors remain enamored of utilities? Or will this sector cool down to traditionally unexceptional levels?

RISKY BUYS. For the last three years, utility stocks have soared, rising from the ashes of the Enron disaster and refuting the impression that the sector is meant only for widows and orphans or conservative defensive investors seeking modest but stable returns. For the three-year period ended Aug. 5, the average utility mutual fund gained 33.6% annualized, vs. a 17.4% rise for the S&P 500-stock index. In calendar 2004 alone, Standard & Poor's Utility Index climbed 32%, vs. a 10.9% gain for the broader index.

Several factors fueled the resurgence of utilities, says Barry Abramson, research analyst with the $210 million Gabelli Utilities Fund/A. The group rose from depressed prices resulting from the dark period of 2000-02, when many utilities courted disaster by imitating Enron and Calpine (CPN) through the purchase of such risky nonutility businesses as energy-trading and marketing.

Then, when utilities found themselves with too much debt and overvalued assets, they sold these ancillary ventures, paid off their obligations, and concentrated on their core utility businesses. Their financial health improved dramatically.

TAX FACTOR. Utility companies are now flush with free cash flow, generated by robust profits, strong balance sheets, and a strengthening domestic economy, Abramson says.

The May, 2003, tax laws, which reduced the average tax rate on dividends to 15%, from nearly 39%, made high-dividend-paying stocks like utilities more attractive to investors, Abramson says. Consequently, utility companies enacted big dividend increases and still continue with relatively aggressive dividend-growth strategies.

The resumption of merger-and-acquisition activity this year has further boosted the sector and promises more consolidation, Abramson predicts. Among the high-profile deals: Exelon (EXC) plans to buy Public Service Enterprises (PEG) for $15 billion, and MidAmerican Energy Holdings, a subsidiary of Warren Buffett's Berkshire Hathaway (BRK.A), made a bid to acquire PacifiCorp for $9.4 billion.

HAPPIER RETURNS? Finally, the regulatory climate for utilities has vastly improved, particularly following the energy crisis in California and blackout in New York City, Abramson says. Utilities are now encouraged by regulators to increase spending on infrastructure like transmission/distribution networks, as well as incentives to invest in nuclear plant construction, alternative energy projects, and clean-coal technologies.

Indeed, one of the biggest attractions of utilities is their steady stream of dividends. John Kohli, portfolio manager of the $1.84 billion Franklin Custodian Fds: Utilities Series/A, believes utilities can keep raising dividends, making the stocks even more appealing to investors.

"Dividend payout ratios are now at about 60% of earnings," Kohli says. "Back in the early 1990s, before deregulation, the dividend payouts amounted to 85% to 90% of earnings. So there's plenty of room for utilities to continue raising dividends."

PLENTY OF SMALL FISH. Consolidation news has also kept the sector in the limelight. Bush's energy bill includes the elimination of the Public Utility Holding Company Act of 1935, a law that made it difficult for utilities to merge. The 1935 law placed restrictions on how much a nonutility investor could own in a utility. Typically, it was capped at 10%.

The U.S. has about 100 publicly traded utility companies -- 70 electric and 30 natural gas. Abramson believes that, through consolidation, that number could decrease to about 60 within five years, and to 40 within a decade. He takes note of the utility industry's fragmentation. "There are a lot of small and medium-size companies and a handful of large companies," he says. "Consolidation in the sector is inevitable."

Some observers believe that big companies like General Electric (GE), or major banks with a lot of cash, will buy electric utilities now that they can.

BILL NOT ENOUGH? On the other hand, Kohli feels skeptical about a potential flurry of M&A among utilities. "I'll believe it when I see it," Kohli says, adding that the recent spate of merger announcements "surprised" him. Despite a favorable new regulatory climate, things tend to move slowly in the utility business, he says: "Each merger could take 18 months to 2 years to complete."

Gary Russell, senior analyst with the $278 million AIM Utilities Fund/A, thinks the President's energy bill neither goes far enough to alleviate the problems of the utility industry nor will necessarily speed up the pace of mergers.

"Realistically, after 20 to 30 years of underinvestment and undercapitalization in the utility industry, there's not much that a single piece of legislation will do to help the industry," Russell says. "It will take a decade or more to properly recapitalize the entire sector, but the energy bill is at least a step in the right direction."

FLOWING CASH. Given the sector's heavy dependence on borrowing and credit ratings, perhaps the biggest obstacle facing utilities lies in the Federal Reserve's commitment to continue hiking interest rates. Utilities flourished during a sustained period of historically low interest rates.

While higher rates will likely hurt the future performance of utility stocks, Abramson thinks the damage will be limited, "because most utilities now have net free-cash flow, so they're not borrowing as much as they used to."

He believes the utility sector is now "fairly valued" but can continue to perform well due to higher dividends, steady and predictable earnings growth, and increased merger activity. Abramson forecasts annual total returns for utility stocks of about 10%.

"STRONG PRICING." Kohli believes that, given the current interest rate environment, utility stocks look "fairly valued to slightly cheap relative to where long-term Treasuries rates are today." Although utility shares may deliver modest returns from now on, he thinks more investors are willing to accept this type of performance in an era of spotty returns for equity markets as a whole.

Despite his reservations about the impact of Bush's energy bill, Russell maintains a bullish outlook on utilities. "The strong economic recovery in the U.S. is driving energy demand ever higher," he says. "Combined with very tight available supply and capacity, we're seeing strong pricing across entire energy spectrum."

While some observers have concerns that utility shares may have grown too pricey, Russell thinks the greater demand for dividend-payers partly justifies richer valuations on utility stocks. He also believes the sector should continue to outperform the S&P 500 for the near term.

STELLAR STATS. The tables below show the five top-performing utility funds for one-year, three-year, and five-year periods through Aug. 5, 2005.

Outside of utilities funds, a few domestic equity funds have significant exposure to the sector. As of the end of July, Copley Fund (COPLX) had 55.8% of its assets in utilities, Kinetics Small-Cap Opportunity Fund (KSCOX), 34.5%; New Alternatives Fund (NALFX), 27.8%; Philadelphia Fund (PHILX), 27.1%; and Primary Trend: Income Fund (PINFX), 26.8%.

Top Utility Funds for 1-year period

Fund (ticker)

Return (%)

ProFunds:Utilities Ultrasector/Inv (UTPIX)

49.9

Jennison Utility Fund/Z (PRUZX)

49

Evergreen Utility & Telecom/I (EVUYX)

44.7

MFS Utilities Fund/I (MMUIX)

39.6

JHT Utilities/III

38

S&P 500 Index

17.4

Average Utility Fund

33.6

Top Utility Funds for 3-year period

Fund (ticker)

Annualized Return (%)

Jennison Utility Fund/Z (PRUZX)

31.3

MFS Utilities Fund/I (MMUIX)

29.8

Evergreen Utility & Telecom/I (EVUYX)

28.3

ProFunds:Utilities Ultrasector/Inv (UTPIX)

25.3

Eaton Vance Utilities/A (EVTMX)

24.6

S&P 500 Index

14.3

Average Utility Fund

21.3

Top Utility Funds for 5-year period

Fund (ticker)

Annualized Return (%)

Franklin Custodian Fds:Utilities Series/Adv (FRUAX)

10.9

Jennison Utility Fund/Z (PRUZX)

8.1

Eaton Vance Utilities/A (EVTMX)

6.3

FBR Gas Utility Index Fund (GASFX)

6.3

S&P Select Utilities SPDR Fund (XLU)

5.8

S&P 500 Index

-1.9

Average Utility Fund

2.3

Ghosh is a reporter for Standard & Poor's Fund Advisor


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