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Warren Buffett is buying utilities. Should you?
On Sept. 18, MidAmerican Energy (MDPWN, news, msgs), 87.4% of which is owned by Buffett's Berkshire Hathaway (BRK.A, news, msgs), bought Constellation Energy Group (CEG, news, msgs) for $4.7 billion, or $26.50 a share.
Other recent purchases he's made in the sector:
- PacifiCorp from Scottish Power for $5.1 billion in 2005.
- $2.1 billion in junk bonds issued by Texas utility TXU in 2007.
- Yorkshire Electricity and Northern Electric in the United Kingdom.
- Rocky Mountain Power.
- Kern River and Northern Natural Gas pipelines.
Price has had something to do with these deals, of course. MidAmerican Energy bought Constellation Energy for just 25% of what Constellation's stock was worth at the beginning of 2008.
But there's more going on here than lower prices. Buffett has made it clear, repeatedly, that he likes the utility business. After buying those TXU junk bonds, for example, Buffett said on CNBC that he wasn't a fan of the junk bond sector. The buy, he said, was a bet on the utility sector.
That bet now stretches back three years, and we're starting to talk about real cash -- $4 billion here, $5 billion there -- so it's certainly worth asking, first, why Buffett likes the sector so much, and, second, whether we should jump on board, too.
10 stocks for your watch list
I have a special interest in the answers to those two questions because though I first wrote about Buffett's interest in utilities in a June 2005 column, "Why Buffett is buying utilities," my own investments in utility stocks this year have been disasters.I bought Exelon (EXC, news, msgs) on Jan. 15 and Edison International (EIX, news, msgs) on July 15. I sold the two just weeks apart in October with losses of 41% and 27%, respectively.
- Talk back: Are you following Buffett's moves this time?
What precisely did I get wrong? Bad timing? Too impatient? Wrong utilities?
And can I now get it right? I think so. This column ends with a list of 10 utility or utility-related stocks to put on your watch list and even, in one case, to buy now.
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First, let me try to reconstruct some of the logic behind Buffett's liking for the sector:
- Because utilities need so much capital, they're a good match with an investor who has billions and billions in cash. Berkshire Hathaway finished 2007 with $44.3 billion in cash and short-term investments. That year the company generated $12.5 billion in operating cash flow. At the start of 2008, Constellation Energy had planned for a capital budget of $2.4 billion.
- Because utilities need so much capital, their stocks have been hit hard by the financial crisis of 2007-08. Constellation sold to Buffett for such a bargain price because chaos in the markets made it impossible for the company to raise the money it needed for everything from its capital spending to its day-to-day operations. (It didn't help, of course, that Constellation had jumped whole hog into trading energy. That gave the company even bigger exposure to the problems at Lehman Bros. (LEHMQ, news, msgs) and other Wall Street financial companies.) MidAmerican Energy was able to strike such a great deal for itself because it promised to inject $1 billion in capital immediately into Constellation.
- Because utilities, even financially stressed ones such as Constellation, generate so much cash, Buffett can buy these shares without worrying too much about when the bear market will end. In many of his recent deals, Buffett has looked to combine the upside potential of stock appreciation with the insurance of a high current dividend. In his investment in Goldman Sachs Group (GS, news, msgs), for example, Buffett got warrants to buy stock at a fixed price in the future, so that if the stock goes up, he profits. And he got preferred stock paying a 10% dividend, so he collects even while he waits for the stock to go up. (By the way, Buffett's preferred stock pays twice the 5% yield taxpayers got on the preferred stock we received when we put money into Goldman Sachs.) In 2008, while Buffett waits for Constellation to recover in the stock market, the company will generate $1.4 billion in cash from operations, according to projections by Deutsche Bank.
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- And finally, Buffett likes the rising future returns in the utility sector. In the next 20 years, the utility industry will need to invest about $1 trillion in new power generation, including nuclear, clean coal, natural gas, wind and solar power, in new transmission lines and grid enhancements, in new forms of energy storage and in environmental solutions to problems such as global warming. Companies that can raise the cash will have almost unlimited places to invest it -- at rates of return that are guaranteed by state utility regulators. So the industry is looking at a scenario where it can put all the cash it generates -- and all it can raise -- to work at a rate of return guaranteed to exceed the cost of capital. Each year, utilities will be able to reinvest their cash flow in new plants and equipment that will, in turn, generate a guaranteed rate of return. And so on and so on, compounding over the next decade or two.
Continued: Why Buffett is different
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