Pick Your Spots in the Power Sector

Ben Warwick is absolutely correct in his discussion of the power industry. As in past market downturns, investors flock to investments that seem stable and predictable and, more importantly, pay dividends. That's why sectors such as real estate investment trusts and some electricity utilities have performed so well in recent months.

Yet, as Ben points out, it's important to know what you're buying. Many investors who bought emerging power companies in hopes of stable returns hung around long enough only to see the plug pulled.

Indeed, it's critical to understand that companies like Calpine (CPN - commentary - Cramer's Take), Dynegy (DYN - commentary - Cramer's Take) and Reliant Resources (RRI - commentary - Cramer's Take) are no more traditional utilities than I am a world class track star.

Hence, a quick review of the criteria an investor might consider when looking for stable utility investments seems appropriate.

In the Spotlight

In July, I highlighted three key measures for evaluating utility investments. First, understand the core business. Companies such as AEP (AEP - commentary - Cramer's Take) and Duke (DUK - commentary - Cramer's Take) are among the largest regulated utilities in the country, with over 75% of their businesses focused on serving retail customers. However, their smaller unregulated businesses have punished the stocks in recent months.

A more recent example of a utility losing focus is TXU Corp. (TXU - commentary - Cramer's Take). Even though this Texas utility is among the elite in the states, its foray into the international markets nearly spelled disaster. On Tuesday, Merrill Lynch analyst Steve Fleishman cut his rating on TXU to neutral from buy, saying the company's European operations continue to deteriorate and will put a sizable dent in the utility's earnings. (Merrill has had a banking relationship with TXU.)

Second, look for a safe yield. In an unpredictable economic environment, it's better to be safe than sorry. So, while you might sacrifice a small amount of yield for safety, follow a simple rule: The best characteristic sweet spot for a traditional utility is a yield in the 4.5% to 5% range and a payout (based on earnings) of no greater than 80%. Also, compare earnings with cash flow to make sure there is a margin for error.

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Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, Edmonds was long Southern Co., although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds.