Useful Utilities
Gregg Greenberg
09/11/06 - 07:16 AM EDT
Labor Day has come and gone, but utility fund shareholders are hoping that,
Fed willing, the summer never ends.
Recent months have been anything but cruel to utility funds. According to fund-tracker Morningstar, the average fund is up 7.6% since the start of June, more than double the rise in the
S&P 500. The spike in utility share prices has also lifted the average fund's year-to-date return to 14.5% -- second only to real estate funds in performance among those ranked by Morningstar.
The source of the sector's surge is not hard to pinpoint. Utility fund portfolio managers readily attribute most of their summer success to declining interest rates and a benign Federal Reserve rate stance. The Fed paused its rate-hiking campaign at its August meeting.
The yield on the benchmark Treasury bond has fallen to 4.8% from 5.1% over the past three months on the hope that a slowing economy will keep the Fed on the sidelines. Meanwhile, the odds of a rate cut at the Fed's January meeting have risen to 14%, up from nil at the start of June, according to Miller Tabak.
Utility companies generally offer high dividend yields, which become attractive to investors when Treasury yields drop. The major power producers also tend to be big borrowers and benefit greatly when the cost of capital declines.
Michael Yogg, portfolio manager for the $539 million
(PUGIX Quote - Cramer on PUGIX - Stock Picks)Putnam Utilities Growth & Income fund, says it's going to be hard to match this summer's move anytime soon. Moreover, he warns that the summer winds that moved interest rates lower could easily reverse if inflation data prove stubborn. That point was exemplified last week when first-quarter unit labor costs were revised sharply higher, to 9% from 2.5%, sending stocks lower and bond yields higher.
But even after last week's scare, Yogg says if you "close your eyes and open them a year from now, then you will see this group much higher, mostly because the Fed has already tightened enough."
Yogg has proved prescient before. Earlier this year, he correctly counseled investors not to fear interest rate "headwinds" when the 10-year Treasury jumped 30 basis points over the course of March, sending utility stocks, as tracked by the
iShares Dow Jones U.S. Utilities Index(IDU Quote - Cramer on IDU - Stock Picks) exchange-traded fund, plunging by 3.3%.
Yogg's top picks in the sector are
Entergy(ETR Quote - Cramer on ETR - Stock Picks) and
Exelon(EXC Quote - Cramer on EXC - Stock Picks), primarily because both companies are in the process of renegotiating contracts to raise power prices. And unlike Baltimore-based
Constellation Energy Group(CEG Quote - Cramer on CEG - Stock Picks), which saw a vicious pushback from Maryland lawmakers when it tried to jack up prices after a long period of low rates, Yogg is confident these two companies will have less resistance.
"Entergy has low-cost nuclear plants in the Northeast, and most of the contracts are more than five years old and will soon be expiring," says Yogg. "And Illinois-based Exelon just started an auction last week which will result in higher prices, but not enough to get the opposition you saw in Maryland."
Judith Saryan, portfolio manager of the $1.26 billion
(EVTMX Quote - Cramer on EVTMX - Stock Picks)Eaton Vance Utilities fund, also called the spring selloff correctly, and she agrees that utility shares will start moving "more on the price of power than interest rates from now on."
"The Fed will cut rates at some point in the next year because they are afraid of a housing collapse," says Saryan. "Meanwhile, the economy won't slow down too much, so the demand for power will remain reasonably strong."
Saryan adds that the sector has also been boosted this year by takeover activity. In February, London-based National Grid announced its plans to merge with Brooklyn-based natural gas distributor
KeySpan (KSE Quote - Cramer on KSE - Stock Picks). That $7.3 billion merger was approved by Keyspan shareholders in August after already receiving approval by National Grid shareholders and antitrust approval from the Federal Trade Commission.
Like Yogg, Saryan is a big fan of Exelon and Entergy, as well as Dallas-based
TXU(TXU Quote - Cramer on TXU - Stock Picks), which has seen its shares almost double since the April rate scare.
"The link with interest rates will always be there, but there is more to the story now," says Saryan. "Less regulation, greater consolidation activity and, of course, the greater appreciation of dividends, should keep investors interested in utility stocks for a long time."
