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Utility Stocks

Finding Value in an Overbought Market

By Roger S. Conrad, on Nov. 9, 2017

The go-go 1960s in the utility sector set the stage for the disastrous 1970s, when inflation and an increased focus on safety and environmental concerns contributed to ballooning costs on major expansion projects. Excessive debt assumed to finance this construction cycle didn’t help matters.

When regulators balked at approving rate-base increases to cover these cost overruns, utilities suffered steep declines in their share prices, and some ended up declaring bankruptcy.

And to the extent that utilities secured rate increases, the consequent ratepayer revolt led to the destabilizing deregulation of some electricity markets in the 1990s—a trend that ended with Enron’s implosion and about two dozen of its peers in Chapter 11 bankruptcy protection or one false move from extinction.

After more than a decade of de-risking and balance sheet repair, the utility sector finds itself in its best financial shape in decades—just in time for a new investment cycle as companies transition from older coal-fired power plants to more-efficient gas-fired facilities and lower-cost renewable energy.

However, with rare exceptions like the Kemper and Vogtle projects, most of these capital expenditures involve significantly less risk and fall in the small to midsize categories. Incremental investments to improve grid reliability, for example, figure prominently in many capital-spending plans.

Utilities can complete these projects much more quickly than the massive baseload power plants of yore, while access to inexpensive capital and the low prices associated with these improvements limit the pain for customers while growing corporate earnings. Many of these investments also aim to extract additional efficiencies and reduce operating costs, further minimizing the effect on overall rates.

Deterioration in utility-regulator relations could threaten this balance. But the incremental nature of many of these projects means that utilities have more leeway to rein in spending if regulatory support erodes.

A reduced appetite for new projects from consumers and regulators would make it difficult for utilities to realize the robust earnings and dividend growth priced into their stocks. We will continue to monitor political and regulatory developments for signs of risk, especially in the aftermath of the recent hurricanes.

All things considered, the near- to intermediate-term future looks bright for utility stocks and the sector’s prospects for earnings and dividend growth.

With the Dow Jones Utility Average making new highs, investors must consider how much of this good news the market has priced in to sector favorites like NextEra Energy (NYSE: NEE), which trades at almost 23 times earnings and yields less than 3 percent.

We must also confront the extent to which the rally in utility stocks reflects technical factors, in addition to encouraging business developments. The growing adoption of passive-investing strategies, for example, can decouple widely held stocks from their underlying fundamentals.

Given how little we read in the investment media and in brokerage reports about the accelerating dividend growth in the utility sector, one wonders whether momentum-based strategies and other technical factors have carried utility stocks higher. Market history has demonstrated repeatedly that when this upside momentum reverses, the downside can be just as pronounced.

Although the utility sector’s valuations make us cautious, we haven’t thrown in the towel and have continued to find value in the market.

Nevertheless, we continue to advocate the following three-part strategy in the current environment:

  • High-grading the portfolio by selling any names whose earnings, guidance and/or business developments raise questions about their ability to weather a challenging economic environment.
  • Building a cash reserve to deploy during a correction by taking a partial profit on stocks that trade at unsustainably high valuations, as highlighted in our table of Portfolio holdings that are above our buy targets. Note that we do not advocate liquidating your entire position in any of these names; we plan to own many of these stocks for years to come.
  • Maintaining a shopping list of high-quality names to buy on a pullback or by setting good-until-canceled limit orders at dream prices. Remember that buying opportunities in individual stocks don’t necessarily depend on movements in the broader market.
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