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When the markets go bad, utility stocks look good

In the battle for investors’ attention, utilities have the upper hand over bonds today, says this U.S. advisory, which has three stocks it likes.

It may not be true that all investors become conservative when the markets start misbehaving, but conservative investments certainly get more attention in times like these.

And at a time when financial stocks are the chief culprits when it comes to misbehaviour, utility stocks would seem to be the number one choice of equities in the conservative camp. Thus the competition for income investors’ dollars is between utilities and bonds.

And according to one U.S. advisory, utility stocks have the upper hand, even though they are down this year. Calculating yields, Dow Theory Forecasts finds utilities are consistently scoring better than bonds.

The bonds in question are U.S. Treasury bonds, or T-notes. The Canadian equivalent would be Government of Canada Bonds, of course. (A similar argument for utilities vs. bonds in Canada would have to be made separately, although yields for Canada and U.S. government bonds are not far apart at the moment.)

Flocking to safety

Utilities and bonds both have attractive cases to make. “Each group has formidable weapons at its command,” says this advisory. “Ten-year Treasury notes offer a risk-free income stream and less price volatility than most stocks. Utility stocks typically offer solid dividends and the possibility of moderate share-price growth.”

Yields on both utility stocks and T-notes have fallen by about 50 per cent since 1995. But on the whole, the 10-year Treasury bond has come in with higher yields than the average utility stock, to the tune of 5.2 per cent as opposed to 4.3 per cent.

But troubled times work against the T-note, adds the advisory. Income investors “troubled by weakness in dividend-paying stocks and worried about the credit quality of corporate bonds have flocked to the safety of the T-note.” The average yield has fallen to 3.33 per cent from 4.03 per cent at the end of 2007 (and the five-year high of 5.32 reached last June). It was up slightly as of Friday’s close, to 3.47 per cent.

The opposite direction

Utility yields have gone in the opposite direction. This year the S&P 500 Utility Sector index has dropped 11.5 per cent. “For the first time since 2003,” says the advisory, “the average utility’s 3.8 per cent yield is above that of the T-note.”

The yields of high-quality corporate bonds have also come down, although they remain higher than utility stocks. Corporate bonds with a Moody’s rating of Aaa have an average yield of 5.35 per cent, about 1.6 per cent above the average for utility stocks — and that’s the smallest spread between the two yields in 15 years.

With the exception of water and hybrid utilities (companies that have both regulated and unregulated activities), every industry in the utility sector averages a higher yield than the Treasury note right now, and all but hybrids yield more than they did a year ago.

Electric utilities stand first at 4.3 per cent, up from 3.4 a year ago. And remember this, says the advisory: “On average, utilities return 60% of their profits to shareholders via dividends.”

Because stock prices have been so strong in recent years, yields are still below historical averages even with the recent fall in prices. But yield alone does not tell the story. This advisory has a list of 15 top utilities and some advice for income investors: while the average yield for this group may be slightly below average, at 3.6 per cent, these utilities offer superior growth potential. That’s something no bond can give you.

Easy to say, not so easy to do

The advisory has one more telling argument against bonds. In a year when utility stocks in general have disappointed investors, why not just put the money into T-notes? Easy to say, not so easy to do.

“It’s easy to say, ‘I could do better than that using Treasury bills.’ And you’d be right — as long as you have the insight to predict exactly when the market will fall, and how long it will stay down. Unfortunately, you can’t. And over time, utility stocks should outperform most bonds.”

The advisory highlights three utility stocks that it believes will do just that. These three all have attractive yields.

AGL Resources (NYSE-ATG) is a natural gas distributor on the East Coast, operating six utilities in states from Florida to New Jersey, and in Tennessee, with about 2.3 million customers. It gathered 27 per cent of its 2007 operating profits from unregulated businesses. These businesses “should account for much of AGL’s growth over the next several years,” says the advisory, “with the natural gas storage business looking particularly attractive.”

Profits were flat last year due to losses in energy marketing and services, and higher capital expenditures will slow profit growth in the short term. But beyond that, things look very good. The energy marketing and service business should pick up in the next few years. Plus AGL’s Golden Triangle subsidiary is building a big natural gas storage facility in Texas. Earnings per share growth is projected to be 4 per cent this year, while AGL trades at just 12 times estimated earnings, below the 14 per cent average for utilities. The yield is a crisp 4.9 per cent.

Duke Energy (TSX-DUK) is one of America’s best-known utilities. The big power company spun off its natural gas pipeline and energy exploration businesses last year. In doing so, “it laid the groundwork for fairly steady per-share earnings growth over the next five years,” says the advisory. It is building coal-fired plants in North Carolina and Indiana, and has filed an application to build a nuclear power plant in South Carolina.

But it is also branching into the alternative energy field. It bought 100 wind turbines from General Electric (NYSE-GE) and more wind energy assets from another source. Overall, it has over 2,500 megawatts of wind power projects in preparation, equal to 30 per cent of its current commercial generation capacity. The yield is 4.8 per cent.

WGL Holdings (NYSE-WGL) owns a gas and electric utility in Maryland, Virginia and the District of Columbia. In March it boosted its dividend by 4 per cent, the 32nd annual dividend increase and the largest in 15 years. The company is saving money by outsourcing some of its business to management specialist Accenture (NYSE-CAN), which should save $170 million over the next 10 years.

Troubles in the housing market will slow customer growth somewhat, but WGL still expects to add 14,000 customers this year. In December, it also received rate increases worth $26 million a year. This stock has held up better than most U.S. utilities this year, falling only 2.8 per cent as against the 11 per cent decline of the sector. WGL expects per-share earnings growth of 6 to 8 per cent over five years, and yields 4.3 per cent.

Utilities ain’t they used to be. Instead of simply delivering one service on a massive scale, many are actively pursuing more businesses, and more growth. That may not make them aggressive growth stocks, but in this advisory’s opinion, it means they can deliver a lot more to investors than bonds.