Juice Up Your Dividends with Utilities
With the economy foundering, this is an ideal time to invest in recession-resistant companies that earn a guaranteed rate of return, pay excellent dividends, regularly raise their distributions and in many instances yield more than 5%. I’m talking about America’s regulated electric utilities.
Yet what should be an obvious destination for good total return, dividend growth and tax-friendly income (the top federal tax rate for qualified dividends is currently 15%) is a surprisingly tough sell. Some advisers scorn utility shares as relics of an obsolete industrial economy or harp on failed diversification attempts and dividend cuts of days long past. “I have to beat people over the head” to make the case, says John Kohli, manager of Franklin Utilities Fund since 1998.
Kohli isn’t here, so I’ll knock you in the noggin with some numbers: This year through September 9, Morningstar’s regulated electric utilities category returned 4.5%, versus a 6.9% loss for Standard & Poor’s 500-stock index (including dividends). Moreover, blue-chip utilities essentially skipped the recent market correction (during which the S&P swooned 17.4% from April 29 through August 8). Dominion Resources (symbol D) and Southern Co. (SO) broke even. American Electric Power (AEP) lost 5%, and Exelon (EXC) lost 4%. Duke Energy (DUK) dropped 6%. But all remained in the plus column for 2011.
There are plenty of reasons to stay bullish. Shares of regulated utilities track Treasury and investment-grade corporate bonds more closely than any other stock category. So the Federal Reserve’s promise to keep short-term interest rates low indefinitely and the terrific performance of high-quality bonds suggest more gains ahead.
The companies themselves are stronger than they’ve been in years. Utilities are running tighter ships, are winning fair rate increases and have ample cash (or can borrow cheaply) to satisfy environmental mandates. Increasingly hot summers boost usage and revenues. Utilities no longer engage in grandiose overreaches, such as buying banks or real estate developments. One recent milestone: In March, El Paso Electric (EE), which spent four years in Chapter 11 bankruptcy, reinstated cash payouts. All 56 publicly traded regulated electrics in the U.S. now pay dividends.
And what dividends! Electrics are on pace to boost their payouts by 7% this year. That follows increases of 8.2% in 2010 and 7.2% in 2009. Count on them to boost their dividends even more because they pay out only 61% of their profits nowadays, down from 85% in the 1990s. At a Barclays Capital conference in September, one utility exec after another pledged to keep raising dividends briskly.
For all that, electric stocks are inexpensive. On average, the group sells at 13 times estimated 2011 earnings. In the mid ’00s, many of the stocks traded at 15 to 20 times earnings. For example, Duke Energy, at $19, sells for 13 times earnings and yields 5.3%. At $42, Exelon yields 5.0% and sells at 10 times earnings. Some of the stocks, including Duke and Exelon, may be cheap because of pending mergers, which cause uncertainty. Regulators don’t just rubber-stamp utility hookups; they often require rate rollbacks or refunds before saying yes. Meanwhile, it may take years for the merged companies to realize cost savings or generate the bigger profits that allow them to boost dividends.
I recommend all of the stocks previously mentioned. Among funds that focus on domestic utilities, Franklin Utilities is the best of the lot. However, if you want to buy the fund on your own, you will likely have to pay a sales charge. I am not enamored of the no-load utility funds, so the best alternative to Franklin is one of two exchange-traded funds: Utilities Select Sector SPDR (XLU) and iShares Dow Jones U.S. Utilities (IDU). The former gets the edge because of its lower expenses—0.20% per year, compared with 0.47% for the iShares ETF.