Power Play on Wall Street

In times past, investors in search of safe investments often turned to utility stocks. Because utilities traded big potential gains for low risk, they provided shelter from a market storm -- perhaps like the one that began in November and has continued into 2008.

But look again. Although utility stocks performed better than Standard & Poor's 500-stock index during the 2000-02 bear market, they still lost a distressing 32% during that 30-month period. And utilities performed far better than the SP 500 in the fat years that followed.

A new trend

For the five years ending last December, iShares Dow Jones U.S. Utilities (symbol IDU), an exchange-traded fund that tracks a Dow Jones index of about 75 domestic utilities, returned an annualized 20%, compared with just 13% annualized for SPDRs (SPY), known as Spiders, the ETF that tracks the SP 500. And when the market as a whole started dropping in late 2007, utility stocks dropped even more. For the first two months of 2008, the Dow Utilities ETF lost 10%, and Spiders sank 9%.

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For many decades, companies that generate electricity or natural-gas heating for homes, offices and industry have had a fairly simple business model: Borrow huge sums to pay for capital projects, such as building coal-fired power plants, and reap the flow of cash from practically captive customers by charging rates set by government regulators.

The environment in recent years has been ideal for utility stocks. Economic growth has been strong and steady, so the demand for power has continued to rise. But interest rates have remained low, so the cost of borrowing is still cheap. Meanwhile, shares of utilities have been attractive to investors searching desperately for secure sources of income -- especially at a time of tax advantages for dividends and paltry coupons for Treasury notes.

Is it any wonder that Warren Buffett has been scooping up utilities for Berkshire Hathaway? It owns 88% of Mid-American Energy Holdings, which does business in the United Kingdom and in midwestern and western states. Last year, MidAmerican's earnings topped $1 billion.

The largest U.S. utility, Exelon (EXC), with 5.4 million electricity customers in Illinois and Pennsylvania and a market capitalization of $52 billion (nearly twice that of the second-largest), returned 19% over the past year to March 3. The SP 500 had a slight loss for the same period.

All of this is good news, but why the apparent volatility? The main reason is that not all utility companies are following the old business model. Many of them have become more adventurous -- exploring for energy, transporting it across the country, selling it to other utilities and manufacturers, and trading it. Enron, let's not forget, was a utility company, among other things.

For example, in its February 11 issue, the Dow Theory Forecasts newsletter contrasts Vectren (VVC), based in Evansville, Ind., and Energen (EGN), headquartered in Birmingham, Ala. Vectren is a conventional provider of natural gas and electricity in the Midwest and receives "more than three-quarters of its revenue from regulated utility operations" (much of the rest comes from mining and selling coal). But for Energen, "the bulk of revenue and 85% of earnings come from faster-growing exploration and production operations."

While Energen finds and produces oil and gas in such places as New Mexico and Texas, Vectren mainly distributes and markets electricity. When fuel prices rise, as they have lately, Energen benefits more than Vectren. But Vectren and other traditional utilities usually aren't hurt by rising oil prices because regulators allow the firms to pass along their costs to users.

Tortoise and hare

You can see the difference between the two companies in their stock charts. The price of Vectren has wavered only modestly since late 2004, generally varying between $25 and $30 a share. But Vectren has also paid an attractive dividend -- its stock yielded 4.9% in early March (when a five-year Treasury note yielded just 2.5%). By contrast, Energen's shares have soared with oil prices, more than doubling since late 2004 but also suffering sharp setbacks from time to time. And Energen investors don't have the comfort of a strong dividend yield: The stock yielded just 0.8% in early March.

As different as they are, the stocks' price-earnings ratios are similar (13 for Vectren and 14 for Energen based on year-ahead profit projections). Although utility-stock valuations have traditionally been lower than that of the market, the P/Es of Energen and Vectren roughly match that of the market as a whole. As a result, Dow Theory Forecasts warns investors that "utility stocks appear expensive." Maybe.

Regulatory mandates

Another complication for utility investors is the changing regulation of pollution and carbon-dioxide emissions. The commission that oversees Edison International, which supplies electricity to 4.2 million customers in Southern California, has mandated that power from renewable sources, such as wind energy, account for 20% of the firm's sales by the end of 2010. Edison is doubling its capacity for wind-driven energy and investing $1.8 billion in new transmission lines to get that power to its customers -- a big investment for a company with $9 billion of debt. The leading utility in wind energy, according to a recent report by the Value Line Investment Survey, is Florida-based FPL Group (FPL), with wind farms in 15 states.

But, at about 2% of total power generation in the U.S., wind and solar are currently an insignificant source of energy and will stay that way for at least the next decade. Coal accounts for half of our power, and natural gas and nuclear provide about one-fifth each.

Although coal, with its domestic abundance, tends to be the least expensive way to generate power, it's also a bull's-eye for environmental groups. So utility executives have tough decisions to make about their portfolio of fuels. That's why a well-run company like NRG Energy (NRG) generates electricity with coal, nuclear power, natural gas, wind and thermal energy.

For the near future, nuclear is at the heart of the matter. Last fall, NRG, a Princeton, N. J., firm that generates power and sells it wholesale (rather than to residential customers), became the first company in 29 years to file a request for a license to build a new nuclear plant in the U.S.

Others, including Duke Energy (DUK) and Dominion Resources (D), which are among the ten largest U.S. utilities, have followed suit. Meanwhile, another of the top ten, Entergy (ETR), based in New Orleans, announced plans to spin off its 11 current nuclear plants as a separate company.

So what are the prospects for this complex industry as it faces fierce challenges? As long as the U.S. economy continues to thrive (yes, even with the occasional recession), the outlook is good. The average utility stock, according to Value Line, currently yields 3.9% -- more than a ten-year Treasury bond. A slowing economy will depress utility earnings, but probably not by much. Stocks of com-panies such as American Electric Power (AEP), Ameren (AEE) and MGE Energy (MGEE) held up very well during the last recession. Energen, by the way, got clobbered.

What to do

The key to owning utility stocks is diversification. Buy a few individual companies, such as Duke, Dominion, Exelon, PPL (PPL), of Pennsylvania, and Southern Co. (SO), of Atlanta, that not only operate traditional, regulated electricity and gas businesses but also generate power that they sell wholesale. Or purchase a portfolio of a dozen or more utility stocks that add the spice of energy exploration and production -- through companies such as Energen and NRG (which trades at a forward P/E of 19) -- to the bland reliability of traditional, regulated electricity and gas distribution.

Unfortunately, many of the large utility-stock mutual funds have huge telecommunications holdings as well. ATT and Verizon represent more than one-third of the assets of Fidelity Utilities. There's nothing necessarily wrong with telecom, but it's a different sector entirely.

The best choices are two ETFs, iShares Utilities and, with nearly the same portfolio, Vanguard Utilities (VPU); the latter tracks the MSCI U.S. Investable Market Utilities index. Each has produced annualized returns of 12% for the three years to March 2. The iShares offering, managed by Barclay's, carries an expense ratio of 0.5%; Vanguard's is 0.2%. In this investment climate -- or any other, for that matter -- utilize utilities.

James K. Glassman is a senior fellow at the American Enterprise Institute.