Utility Stocks Struggle for
Staying Power
By
Gregg Greenberg
TheStreet.com Staff Reporter
4/10/2006 7:31 AM EDT
Is this "the big one Elizabeth"?
Utility fundholders are staggering around, near-dying to know.
Fans of '70s sitcoms may recall that Fred Sanford, a character played by Redd Foxx on the show Sanford and Son, would often fake a massive coronary and alert his dear, departed wife Elizabeth that he would soon be joining her. Whenever Fred was in a serious jam, his first option would be hysterically feigning "the big one," treating viewers to a big laugh in the process. Like good old Fred, utility stocks have also set a pattern of crying wolf when things get tough, only to quickly snap back to health. These cardiac episodes, however, rarely amuse shareholders. The entire sector was decimated in 2001 to 2002 because of the decisions by a few energy providers to chase rogue companies like Enron into the energy trading business. Eventually the group bottomed out and, aided by the dividend tax cut passed in the spring of 2003, started to recover. That was until the next heart-grabber, the big Northeast blackout in the summer of 2003, which not only caused utility stocks to stumble but also called into question the nation's aging power grid. Once the juice started flowing again, the stocks rose magnificently as the Fed repeatedly lowered interest rates and energy prices moved higher. The false alarms were sounded again -- and with similar results -- in March and October of last year amid interest rates spikes, the nemesis of yield-based stocks. Investors are tempted to abandon utilities' steady payouts in favor of safer Treasury coupons when their yields become competitive. The most recent occurrence took place just last month, when the benchmark 10-year Treasury jumped 30 basis points over the course of March. As a result, the stocks, as tracked by the iShares Dow Jones U.S. Utilities index (IDU:Amex - news - research - Cramer's Take) exchange-traded fund, fell 3.3%. Moreover, Treasury yields have refused to relent in April, and on Friday they reached their highest level in nearly four years |
So should utility fund investors
slough off this latest episode as another overreaction? Or could it really
be "the big one Elizabeth"?
"Higher rates are not necessarily the death knell for utility stocks, but there is a larger correlation between rates and the sector than there has been in two years," says Leslie Rich, analyst for the $374 million Columbia Utilities fund. "The restructuring, dividend and commodity stories are over." Judith Saryan, portfolio manager for the $962 million Eaton Vance Utilities fund, has an attitude much like Fred Sanford's son Lamont. "It's another head fake, and the hard part is knowing how long it will last before they turn positive again," she says. Naturally, It's Gas PricesInterest rates steadily dropped during 2003 and 2004, yet, according to Rich, the real force behind rising utility share prices was corporate restructuring after the massive decline. These companies benefited greatly from the ability to get their balance sheets in order through refinancing their massive debt loads. From a public investor's point of view, the utility story was more about choosing turnaround candidates with legs than about comparing the utilities' yields with those of Treasury bonds. Rich says that changed in 2005, when energy prices became the main driver of utility appreciation, especially for power generators that can extend their margins when natural gas prices are lofty. Natural gas prices fell during the recent mild winter from over $10 at the start of the first quarter to under $7 at the end of March. Moreover, people were using less power, which hurts both the regulated and deregulated companies. With natural gas prices no longer propelling stocks, Rich says that the focus will shift back to rates. Eaton Vance's Saryan shrugs off the decline in natural gas prices, saying they will be volatile but won't collapse because of rising global demand. |
"Nowadays, natural gas is going to the
highest bidder, and that bidder may very well be in Europe or Asia," says
Saryan.
In Saryan's view, the better performers in the current environment will be growth utilities that are aligned with commodities. That suggests less-regulated companies with power-generation capabilities, such as Exelon (EXC:NYSE - news - research - Cramer's Take), TXU (TXU:NYSE - news - research - Cramer's Take) and Edison International (EIX:NYSE - news - research - Cramer's Take). Worse off in a rising rate environment will be more tightly regulated energy providers such as Southern Co. (SO:NYSE - news - research - Cramer's Take) and Con Edison (ED:NYSE - news - research - Cramer's Take). "The knee-jerk reaction when rates jump is always to the down side, but then investors look for opportunities by separating the generators from the regulated companies," says Saryan. Michael Yogg, portfolio manager for the $549 million Putnam Utilities Growth & Income fund, brings another factor into the utility debate: politics. There is a growing political backlash from rising power prices, especially in states such as Maryland and Delaware. Maryland lawmakers are reportedly weighing a 5% annual limit on rate increases amid evidence that Baltimore Gas & Electric, a unit of Constellation Energy Group (CEG:NYSE - news - research - Cramer's Take), is planning to sharply raise prices in July at the close of a six-year rate freeze. The political pressure even caused executives at FPL Group (FPL:NYSE - news - research - Cramer's Take) and Constellation last week to question their proposed merger. To block the company's planned rate increases, the Maryland legislature has passed several bills, including one that would prohibit the merger unless Constellation spends $528 million to reduce rates. "The spate of rate increases are bad publicity, and that's not good in an election year," says Yogg, who also likes Exelon because its nuclear power generation capabilities guarantee cost stability. He is also sweet on California-based PG&E (PCG:NYSE - news - research - Cramer's Take), which he says is still transforming itself in the wake of the California energy crisis. California politicians are bent on making sure a higher portion of the state's energy needs are controlled by in-state utilities instead of the out-of-state providers -- like Enron -- which led to massive shortages in 2000 and 2001. Natural gas prices, politics ... but what about interest rates? "The Fed is going to raise rates, which affects all stocks, but it is a headwind, not a hurricane," says Yogg. "If you can take the volatility, then you should ride it out." At least, as long as your heart can fake it.
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