Monday Morning: Steady pace wins the race for utilities

Fifty years ago, utility stocks were a key part of many portfolios, especially for those who were retired or close to retirement.

Unfortunately, many investors abandoned utility stocks during the go-go years of the 1960s, and though a few came back to them briefly in the wake of the 1973-74 bear market, most soon abandoned them again.

Utility stocks were boring. They weren’t growth stocks. They paid out a high percentage of their earnings to shareholders in the form of dividends, instead of retaining them in the company to finance growth.

Most investors, it seemed, would rather have the prospect of a significantly higher stock price in the future than a certain dollar today. That is, they would rather have two birds in the bush rather than one in the hand.

tricky goal

To introduce a new metaphor, utility stocks seemed like tortoises, and most investors wanted to invest in hares. That was why Enron Corp. tried to transform itself from a utility into a trading company – trading companies seemed to promise faster earnings growth and were rewarded with higher price-earnings multiples and stock prices.

But William H. Reaves, founder of W. H. Reaves & Co. in Jersey City, N.J., maintained his faith in utilities over the years and has seen it amply rewarded. Since it began managing money for clients in 1978, his company has earned a compound annual return of 17.1%. According to Ibbotson Associates of Chicago, large-cap stocks have returned 14.7% annually in the same period.

Even over the past 10, five and three years, the tortoises have won. Mr. Reaves’ company has beaten the Standard & Poor’s 500 stock index handily in all three periods. Slow and sure wins the race.

Given all the bad publicity about Enron, are utilities still a good place to look for investments?

“Yes, but you have to pick your spots,” says Mr. Reaves. “The outlook for a selected number of them is probably two or three times what it was under the strict regulation environment. You have about half of the states that have moved to deregulation, and of that half, several of them are still pretty rotten, and Connecticut is one of them.

“But some states have come through extremely well: Virginia, Ohio, Texas, and in varying degrees, New Jersey, Pennsylvania and Maryland, and there are some real opportunities. But the basic business of selling power to your house and mine is going to stay regulated for a long time.”

Nevertheless, Mr. Reaves says, the outlook for some companies is very, very good. “If you can come up with 8% to 10% compound growth in earnings, and you have a dividend yield anywhere from 3% to 4.5%, to almost 5%, that gives you a combined return anywhere between 12% and 15% or 16%, with some reasonable degree of sureness. I think that’s a wonderful return.”

One outcome of the Enron scandal, says Mr. Reaves, is that the basic utility model will remain in place in some states because the deregulation movement has been stopped in its tracks. Under the normal utility model, some companies still do quite well, he says, companies like Scana Corp. in Columbia, S.C., and FPL Group in Juno Beach, Fla.

Now may be a time to buy. Many utilities have reported lower earnings because of the warmer-than-usual winter, and stock prices have come down.

good returns

“You have to be selective,” Mr. Reaves says. “You have to give some thought to what bad could happen. With reasonable selection, they are better than safe harbors in that you have good value buildup, a more robust buildup of value than you could have expected when they were in the tight grip of regulation.

“If you can compound at 12% a year with a combination of earnings and dividends, with reasonable certainty, I think that’s wonderful,” Mr. Reaves says.

A utility will never be a growth company, he says, but a utility can be a “nicely growing company.” W. H. Reaves & Co. manages the Strong Dividend Income Fund, which used to be called the Strong American Utilities Fund. It also manages about $1 billion of tax-exempt assets for pension funds, foundations and endowments.

Now that many of the hares have stumbled or been taken out of the race, Mr. Reaves’ tortoises appear more attractive, especially in tax-exempt accounts such as 401(k)s, Keogh plans and individual retirement accounts, where the dividend part of the total return can be sheltered from income taxes.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.