Plying the Power Lines

Utility funds have been on a roll, but managers say the fun is far from done.
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Talk about a power play.

Low interest rates, the 2003 Bush dividend tax cut and good old fashioned momentum have lifted the Dow Jones Utility Index by more than 80% since the summer of 2002. The average utility fund is up 20% annually over the past three years, according to fund tracker Morningstar.

After three years in rally mode, can the utility sector keep the juice flowing? Some hard-hitters say yes.

"As long as the economy remains in a slow growth mode, the outlook remains good for utilities," says Judy Saryan, portfolio manager of the $761 million

(EVTMX) - Get Report

Eaton Vance Utilities fund. "The fundamentals have not changed."

Saryan's fund is up 11.4% this year and 23% annually over the past three years.

Saryan likes to see the economy looking more like a tortoise than a hare, because rapid growth could boost inflation and spur interest rates higher. Any spike in long-term rates could hammer these shares, because these companies tend to be big borrowers. Investors seek out utilities in low-interest-rate environments for their dividends.

Longtime players in utility stocks still fear a repeat of 1994-95, when the

Fed

essentially doubled the overnight lending rate, triggering a 33% plunge in the utility index.

A decade later, the Fed is once again trying to curb inflation by lifting short-term rates. But this time Fed Chairman Alan Greenspan's efforts have yet to bear fruit. Long-term interest rates are lower now than they were last year, when Greenspan started his tightening campaign. And many big-time bond strategists, such as Pimco's Bill Gross, don't foresee long rates heading north anytime soon.

Shaun Hong, co-portfolio manager for the $3.2 billion

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Jennison Utility fund, says "the entire stock market is in trouble if the yield on the 10-year Treasury goes up from 4% to 6%, not just utilities." Hong's fund returns have been far from troublesome for his investors: The fund is up 17% year to date and 27% annually over the past three years.

It's Not Just Low Rates, Stupid

Low interest rates aren't the only factor stoking the rally in utility shares. Higher commodity prices are also helping -- even though higher commodity prices often cause a spike in interest rates, and this brings us back to the Greenspan rate-curve conundrum.

"Rising energy prices have been the biggest factor in the resurgence of natural-resources funds, but they're also a major reason why utilities funds have done so well," says David Kathman, utility analyst at Morningstar. "Most utilities funds own at least some energy stocks, and a number have relatively hefty double-digit stakes."

Eaton Vance's Saryan favors deregulated utilities because they tend to move with commodity prices, "which look like they are staying at elevated levels."

Saryan likes Pittsburgh-based

Equitable Resources

(EQT) - Get Report

, for example, because it has exploration-and-production operations aside from its gas distribution business.

Exelon

(EXC) - Get Report

is another of her top picks. Exelon produces nuclear power, so it is less affected by higher oil prices and can expand its margins.

Fund managers and analysts also don't seem spooked by the rising valuations for utilities. Typically, the sector sells at a 15% discount to the market, but lately it has risen to a market multiple of 15 times 2006 earnings.

"The stocks are extended, but not at a top," says Phil Roth, strategist at Miller Tabak.

And there are still some bargains to be had, says Jennison's Hong, such as

Sempra Energy

(SRE) - Get Report

, a Southern California utility trading at 13 times 2006 earnings.

Rising stock prices and expanding multiples, however, mean lower dividend yields -- a potential problem when a steady payout was a major attraction for utilities in the first place.

But even with the recent decline in dividend yields, utility payouts are still plenty rich. The

iShares Dow Jones U.S. Utilities

ETF

(IDU) - Get Report

, for instance, is currently yielding 2.7%, against the

S&P's

1.8%. And many high-quality utilities pay even more.

And more yield-hungry investors could be on the way should real estate falter, says Don Cassidy, strategist at Lipper.

"If people start getting nervous about a real estate bubble, they may shift from REITs and homebuilders into utilities so they won't lose the yield," says Cassidy.

With so much riding on their ability to maintain their dividend payouts, perhaps the biggest question is whether utility companies can keep generating the cash to send to shareholders.

Mark Finn, a utilities analyst at T. Rowe Price, says this shouldn't be a problem in the second half, as cash flows in the industry remain strong and may even grow stronger.

"Higher cash flows may or may not translate into much higher stock prices from here," says Finn. "But the fundamentals are still favorable."

That said, any time a sector runs up so far so fast, it usually brings out a few warnings from analysts. Even if the sector is boring old utilities. Well, formerly boring utilities.

"Utilities funds have continued their recent roll, but caution is still warranted," says David Kathman, a utility fund analyst at Morningstar.

To view Gregg Greenberg's video take on the utility fund sector, click here.