Jim Jubak

Jubak's Journal7/15/2008 12:01 AM ET

Get better returns with less risk?

Utility stocks may outdo the markets for the next few years. But not all companies in this sector will thrive. Here's how to pick the likely winners.

By Jim Jubak

Utility stocks are a traditional haven when fear rules the stock market. The sector has certainly worked that way since March.

Since the low in the Dow Jones Utility Average ($US:UTIL) on March 28 -- roughly two weeks after the Dow Jones Industrial Average ($INDU) put in a temporary bottom March 10 -- through the market's close on July 10, the utility sector has climbed 10%. In that same period, the Dow industrials are down 8%.

With the bear market still raking its claws through portfolios, getting that kind of performance and safety is obviously an attractive option today.

But there are other reasons to buy utility stocks now that make some of them a long-term growth story:

  • Soaring energy prices.

  • Impending energy shortages in major regions.

  • The ending of a long period of chronic underinvestment in the distribution grid.

  • Likely action to tackle global climate change.

Over the next five to 10 years, these electric utilities could well match or better the return on the major market indexes with less than market risk.

Not all utility stocks will share that good fortune. Some, in fact, will be victims of the same trends that will lead to outperformance by their peers. Over the next five years, the difference in performance between the right utility stocks and the wrong utility stocks is likely to be huge.

So how do you get on the right side of that performance story? I've got five simple steps to follow. I'll lay them out below. And then I'll end the column with three picks from the sector. One of them is already a Jubak's Pick. I'll add another utility stock to the portfolio with this column.

  • Step 1: Look beyond yield. Utility dividends are important in the short run, so I wouldn't ignore them completely. The 2.2% dividend paid by Exelon (EXC, news, msgs), for example -- just slightly less than the yield on a two-year Treasury bill -- is one reason the stock has held up so well in a bear market. But for the long term, a high dividend may be exactly what you want to avoid and a low dividend exactly what the market ordered.

  • Step 2: Look for utilities adding assets to their rate bases. Regulators set the revenue a utility can collect based on a set percentage return on the value of its assets. Thus the more valuable a utility's assets, the higher its revenue. For the long run, then, you'd like to find a utility that's adding power plants, power lines and other assets to its rate base. A utility investing in assets for the future, however, may not be able to pay much of a dividend now, which is why a low current dividend may be exactly what you'd like to see.

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  • Step 3: Look for state utility regulators that reward utilities for adding assets. A regulator doesn't have to give a utility a market rate of return on its assets or include all of the utility's new assets in its rate base. The regulator could find, for example, that the proposed -- or worse yet, recently built -- power plant isn't justified by current forecasts for electricity demand and refuse to put part or all of it into the rate base. That could kill a utility's return in the near term and discourage the company from investing to meet future needs. What you'd like to find are state regulators who recognize that the utility industry faces a crisis. Years of underinvestment in the grid and distribution system have left utilities unable to get power where it needs to go with any kind of efficiency. Many states are also now looking at significant shortages of electricity in the next few years because utilities haven't invested in enough power plants. As an investor, you want to find a combination of a utility and a utility regulator that both recognize the need for big investments in capacity and distribution now.

  • Step 4: Look for utilities with the right mix of assets and assets under construction. One of the reasons that I had added Exelon to Jubak's Picks is that the company owns 17 nuclear units that generate about 18% of all electricity generated by nuclear power in the United States. As the cost of coal, natural gas and oil rise, those nuclear plants get more and more valuable, because they generate electricity at about half the cost of the most efficient coal-burning plant. And they generate that electricity without producing any greenhouse gases. Any scheme to tax, regulate or cap greenhouse gas emissions will just increase Exelon's cost advantage. Other types of assets that investors want to own for the long run include wind power farms, solar power plants and smart grids, which let a utility manage demand on its system to minimize the use of expensive peak-power generators.

  • Step 5: Avoid utilities with the wrong assets. Whether the next administration decides to tax carbon admissions, regulate them, cap them or set up a market to trade them, utilities that use coal to generate electricity are looking at rising costs. That's going to spell the death of the 20% or so least efficient coal-burning plants in the U.S., according to estimates by utility Edison International (EIX, news, msgs). The utilities that own those plants will either see their rate bases -- and thus their revenue -- fall or have to spend lots of cash to build plants at a time when construction costs are rising at better than 15% annually.

Continued: Three examples

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