More Power to Utility Stocks

At a home down the street from mine in a leafy Maryland suburb of Washington, D.C., work crews just installed a set of solar panels. I don’t know the homeowners, who arrived last winter and obviously plan to do less business with Pepco, our electric company, than the rest of the folks on our cul-de-sac do. We’re pleased that Pepco (symbol POM), which has an awful storm-related reliability record, is being acquired by Exelon (EXC). But should investors in Exelon worry that people in my neighborhood—or the next one over or the one after that—are galloping to get off the grid? I biked around and saw no signs of that, despite the subsidized loans and state and federal tax credits available for solar installations.

That brings me to the performance of utility stocks, which are having a great 2014. Through May 30, the Dow Jones utility average has delivered a total return of 11.1%, compared with 1.9% for the Dow Jones industrial average and 5.0% for Standard & Poor’s 500-stock index. I am not shocked by utilities’ stellar results.

Solar mania is just the latest wrongheaded argument for the idea that traditional electric utilities are obsolete and their stocks are doomed. Solar-power output is growing rapidly, especially in sun-drenched California and Arizona. But most of that growth comes from utilities tapping the rays to produce juice for resale, not from the homeowning public adding so much solar energy that it threatens to dispatch Local Power & Light to the dustbin, alongside Blockbuster Video. Plus, utilities are adding far more generating capacity from natural gas. Their solar efforts are a buffer against the risk that cheap and abundant gas will become unavailable.

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There are plenty of other flawed arguments against investing in power com­panies. Among them are the likelihood of rising interest rates, the threat of regulators trying to score political points by capping or reducing investor returns, a history of stupid acquisitions, and a perception that the industry is mismanaged because smart people enter more exciting fields. The stock market generalists I question about utilities believe all of the above, so they usually pan the sector. By contrast, utility analysts and managers of utility funds give the companies they follow high marks for solving problems and controlling their appetite for ill-fitting nonregulated ventures.

Valid concerns. Not everything is sunny in utility-land. Duke Energy (DUK) may need to spend $10 billion—the equivalent of four years of profits—to clean up toxic coal-ash ponds in North Carolina that poison rivers and soil. Southern Co. (SO) is building two nuclear reactors in Georgia that are three years behind schedule and more than $2 billion over their estimated $14.3 billion cost. New York’s Consolidated Edison (ED) is picking up the pieces from Hurricane Sandy by “hardening” its system at a cost to the company (read: investors) of more than $1 billion. I don’t recommend ConEd, Duke or Southern, all of which trail the Dow Jones utility average so far in 2014.

But for steady, albeit modest, growth and above-average dividend yields, it’s hard to top utility stocks. Investors can choose from among 55 regulated electric or gas-and-electric utilities. You can gain exposure to the entire sector by buying Vanguard Utilities (VPU, 3.4% yield), an exchange-traded fund. Among actively managed mutual funds, the best choice is Franklin Utilities (FKUTX, 2.8% yield). Choose it if you can avoid the sales charge. If you’d rather invest directly, buy a bunch of utilities to minimize the risk of a Duke-style disaster. My favorites are American Electric Power (AEP, recent price $53, yield 3.7%), National Grid (NGG, $75, 6.1%) and Xcel Energy (XEL, $31, 3.9%).