Utility stocks trade at a discount to the stock market as a whole -- and, right now, at a bigger discount than usual.
The forward price-to-earnings ratio based on projected earnings for the next 12 months is just 80% of the forward P/E ratio for the market as a whole. The long-run average is 85%.
Yet I don't think the sector as a whole is a roaring buy. In fact, I think the average utility stock is overpriced.
How can the sector be cheaper than the long-term average and overpriced at the same time? Because uncertainty and risk for the sector as a whole have soared. To find a utility stock to buy -- and I'll give you three suggestions, including one buy, at the end of this column -- I think you need to find shares of those few utilities that have navigated a clear course around those risks or that have lucked into a way to avoid the worst risks.
What are the risks? You don't need to take off your shoes to count 'em. Two hands will do (or one if you're Anne Boleyn):
- Stronger-than-I-expect economic growth in 2010 that hits utility stock prices hard. (That would be growth like the Federal Reserve's projection of 3% to 3.5% rather than my estimate of 2%.)
- Fuel prices, especially currently low coal and natural-gas prices, that climb faster than utility regulators will allow utilities to increase rates.
- Higher interest rates from the Fed that cut the prices of dividend-paying stocks.
- Higher interest rates in the bond market that make raising money for capital investment more expensive.
- New Environmental Protection Agency rules on carbon dioxide emissions that require massive new capital spending. (For a summary of the EPA's recent regulatory moves on carbon dioxide, see this post on my blog.)
- Energy-efficiency incentives that keep demand lower than expected even in an economic recovery.
Pick a utility -- any utility -- and you can see these issues at work.
More from MSN Money and MoneyShow.com
Risks and rewards
At American Electric Power (AEP, news, msgs), for example, the slow economy hurt the company's sales in a core service area that serves 5 million retail customers in 11 states. Two of those states, Ohio (39% of the company's revenue) and Indiana (16%), have been particularly hard hit by the recession.American Electric Power has built a good business in using its central location to supply power to other utilities. But these out-of-system sales took a hit in the recession. Rules that restrict the company's emissions of carbon dioxide could turn another one of American Electric Power's competitive advantages -- its proximity to the coal fields of Appalachia -- into a liability. (The company gets 86% of its power from burning coal.)
But this being the utility sector, where the rules of what we call free-market economics often get turned on their head, not all these risks work out quite the way you'd expect. And to understand their impact you need to dig deeper into what seem to be obvious risks.
So, for example, the need to invest capital to control carbon emissions isn't nearly as dire as it seems from my list. Capital investments are a part of how regulators determine rates, and the return that a company such as American Electric Power gets on these investments in its regulated utility business can help fill coffers that ring a little emptier because of slower economic growth.
American Electric Power's central location has given it a pipeline of long-distance transmission projects because the company is positioned as a key link in any attempt to connect the country's three relatively unconnected regional electric grids. Interstate transmission lines are regulated by the Federal Energy Regulatory Commission, or FERC, which has approved relatively higher returns on investment in an effort to fix decades of underinvestment in the national grid. The relatively lower capital requirements of transmission lines, in comparison with power plants, make this an especially attractive investment in a time when raising capital is difficult and likely to be increasingly expensive.
Continued: 1 to buy, 2 to watch (at least)
