See David Peltier's video of utility companies with safe dividends and those investors should avoid. Peltier is portfolio manager of the Dividend Stock Advisor.
For investors who have thrown in the towel, it's worth considering utilities funds.
After they collapsed during the bear market of 2000 to 2002, some analysts gave them up for dead. Then, without much fanfare, utilities funds recovered and raced ahead.
During the five years ending in January, utilities funds returned 6.2% annually, outdoing the
by 10 percentage points and beating every domestic equity category except precious metals, according to Morningstar. Utilities funds remain solid options for surviving the recession. Their saga demonstrates how battered funds can change their ways and eventually rebound.
The trouble for utilities funds had its roots in the go-go markets of the late 1990s. Up till then, utilities funds had been conservative, holding mainly regulated electric producers and telephone companies that provided safe dividends.
With technology companies soaring in the bull market, some utilities funds moved away from the stodgy approach and bought hotter stocks, such as
, the razzle-dazzle energy trader, and
, a fast- growing telecom giant.
When the high-flyers crashed, utilities funds collapsed. In 2001, the funds dropped 20.7%, trailing the S&P 500 by nearly 9 percentage points. Utilities funds went on to lag the benchmark by wide margins for the next two years.
Seeing the damage, a Morningstar analyst wrote an article in 2002 headlined, "Are Utilities Funds Worth Owning?" The answer was no. In their latest incarnation, the funds no longer offered secure income, the analyst said. It was not clear that utilities could provide growth that would match the performance of diversified equity funds.
Some fund companies agreed with the criticism. Convinced that the sector was too narrow,
Vanguard Utilities Income
changed its mandate to include a range of dividend-paying blue chips. The fund was renamed
Vanguard Dividend Growth
. In the next few years, several other companies, including
, also broadened the portfolios of their utilities funds.
The shifts away from utilities came just as the sector was moving into high gear, churning out double-digit returns for five straight years. Instead of owning one of the newly broadened funds, most investors would have gotten higher returns with a pure utilities choice. For example, Vanguard Dividend Growth returned 0.4% annually during the past five years, a strong showing despite the market crash, but nearly 6 percentage points behind the average utilities fund.
Funds that continued to focus on utilities enjoyed a revival because of a variety of factors. First, some of the funds moved away from high-flying stocks and returned to steady performers with reliable earnings. That proved to be a winning move. After being battered in the downturn of the early part of the decade, regulated utilities rebounded nicely as the markets favored solid businesses. The rich dividends of more than 4% appealed to investors who sought income at a time when bond yields were skimpy. In addition, rising energy prices benefited many portfolios, including funds that held unregulated gas companies.
Investors seeking a stable choice now should consider
. Portfolio manager John Kohli holds mostly rock-solid regulated electric companies. Because regulators permit power producers to raise prices when necessary, the utilities should maintain healthy profit margins during the recession. A big holding is
, a Florida electric producer with a secure dividend.
During boom years, such as 2006 and 2007, Franklin trailed competitors that held telecom and energy stocks. But the conservative fund outperformed when the going became difficult. In 2008, Franklin lost 25.6% -- more than 11 percentage points ahead of the S&P 500.
More aggressive investors may prefer
, which returned 8.5% annually during the past five years, exceeding 92% of its peers. Portfolio manager Maura Shaughnessy favors companies that can grow a bit faster than their competitors. While she owns some regulated utilities, Shaughnessy also holds non-regulated producers that sell gas and electric in the open markets. Such companies can score big gains when demand rises and prices climb. A big holding is
, an unregulated power producer.
To find extra earnings growth, MFS has bought some overseas companies that enjoy increasing demand. A longtime holding is
, a Mexican provider of wireless and fixed-line telecommunications.
Another top performer is
Evergreen Utility and Telecomm
, which returned 9.8% annually during the past five years -- more than 98% of competitors. Portfolio manager Timothy O'Brien holds a mix of cautious and aggressive choices. During the boom years, he emphasized growing companies that could benefit from rising energy prices. In the past year, he turned defensive, focusing on regulated electric companies that seemed likely to suffer less during the recession. A favorite stock is
(POM), a regulated power producer serving Washington, D.C.
Solid companies like Pepco should continue delivering steady dividends and help utilities funds weather difficult markets.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.