Winds of Change Blowing Through Utilities Sector

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Does it pay to be utilitarian in this market?

That's a question on many minds pondering the recent market gyrations. With the rapid price movements seen at the close Wednesday and the sharp declines on Tuesday, many investors are looking for ways to squelch volatility in their portfolios.

Enter the old mainstay of conservative investors -- electric utilities. After all, most electric utilities fluctuate much less than the general market, typically pay a steady dividend and peddle a product that is in demand during all phases of the economic cycle. Investors with a penchant for stability have been willing to give up the potential for the "home run" for a known, conservative investment -- their local electric utility.

But beware. A new era in power investing has arrived. In what many term a historic bull market, some have overlooked one of the best performers of the past 12 months: the

Dow Jones Utility Average

. Since last August, the "stodgy" utility index has gained just over 17%, while the

Dow Jones Industrials

has posted a gain just short of 3.5%. Utilities have even outperformed the

S&P 500

, which has gained 12.61% since last August.

One possible reason for the stellar performance of the index is the downtrend in interest rates. Because capital-intensive utilities historically carry large debt loads, they tend to track more with interest rates than with the broader equity market. However, since July, as rates have continued their descent, utilities have fallen with the broader market, with the index posting a decline of just over 7%.

With conflicting signals from the power industry, one wonders whether the surge in electric stocks over the past 12 months signals a change in the nature of the industry.

"Most of the gains occurred in November and December," said

Edward Jones

analyst Robin Diedrich. "With little Asian exposure, there was a flurry of electric utility buying toward the end of 1997. Utilities looked like a secure domestic play in December, especially with investors looking to protect their large gains toward year-end."

Indeed, much of the gain of the past year can be attributed to a quick rise in prices during the last two months of the year. The utility index rose 12.6% from Nov. 1 to Dec. 31, 1997, much greater than the 6.5% rise in the S&P 500 during the same period.

The index continued its ascent through the first quarter of 1998, albeit at a much slower pace, gaining only 4.7% in the first three months of the year. That compared to a gain of 13.5% in the S&P 500. The quarter was characterized by profit-taking early in January followed by a typical "winter rally" in February and March. Over the period from November to April 3, 1998, the utility index gained 19.7% but since has trended downward.

The decline can be attributed, in part, to the poor performance of gas companies in the index like

Consolidated Natural Gas

(CNG)

,

Columbia Energy

(CG) - Get Report

and

Williams

(WMB) - Get Report

. Both demand for natural gas and prices sagged in the early part of the year, a result of a warmer-than-expected winter. "Gas companies had a poor first and second quarter," said Diedrich. "Pricing and demand were very weak."

While not as pronounced, electric utilities have traded flat to down since April as well. This while interest rates have continued to trend downward, which historically is bullish for utility stocks. Moreover, with the exception of a brief period in May, the utility index looks very similar to the Dow Jones Industrials, including a significant selloff from July highs. Could it be that the nature of electric utility investing is changing with the industry?

At least one analyst thinks so. "It used to be that debt instruments were the capital investment of choice of electric utilities," said

BT Alex. Brown's

Edward Tirello. "However, that began to change in the mid-1980s. Interest rates aren't as important a predictor of electric utility stocks as they used to be."

Tirello believes there are a host of other factors beginning to influence the decision to invest in power companies. "We are starting to get other things in the mix

of news moving utility stocks," he said. "The move toward deregulation, state action allowing or disallowing recovery of stranded costs, nontraditional business lines and the decoupling of generation and transmission are all factored into the utility investment calculus today."

As the electric utility industry undergoes the transformation toward competition the characteristics of power company stocks are also changing. The past two generations have invested in electrics for their stability and, more importantly, their growing income potential. Many retired investors traditionally bought utility stocks as an alternative to fixed-income investments due to growing dividends and stable stock prices.

However, the past decade has seen the dividend growth slow, with last year providing the smallest dividend hikes in any year since the 1930s. "The focus going forward will be as much on earnings growth as dividend growth," said Diedrich. "Dividends have been relatively flat for the past 10 years. Fewer and fewer utilities will increase their dividends in the years ahead."

As deregulation becomes a reality, companies will reduce their payout ratios and redeploy earnings and cash into research and new technologies in an attempt to stay one step ahead of their newfound competitors. Many investors are discovering that electric utilities no longer provide the bond surrogate their parents relied upon for steady income growth.

Dividends also provided a cushion for total-return investors during precarious markets, giving utilities a reputation as a safe haven in volatile times. While dividend growth is slowing, select utilities can still provide shelter during a market storm.

"Utilities remain a safe haven, although you must be more selective," said Tirello. "You have to look for utilities that have great managements and have clearly articulated a plan for the future -- a future that looks very different than the past." On Tirello's short list are

Western Resources

(WR)

,

Houston Industries

(HOU)

,

Texas Utilities

(TXU)

,

FPL Group

(FPL) - Get Report

and

Duke Power

(DUK) - Get Report

. He also likes regionals

CMS Energy

(CMS) - Get Report

and

Northwestern

(NOR)

.

Generally, Diedrich agrees. "You can't say that

utilities are safe havens to the same degree as before. They simply aren't the same income vehicles they once were. However, the right utilities still can prove rewarding in volatile times." Her select list includes Duke and

NIPSCO Industries

(NI) - Get Report

as well as

Southern Companies

(SO) - Get Report

and

Utilicorp

(UCU)

. Both Duke and NIPSCO, Diedrich believes, will continue to provide dividend growth above the industry average and deliver earnings growth of 6% to 8% in an industry she believes may not grow earnings at all, on average, over the next several years.

No doubt, the electric industry is changing. Both the characteristics of individual companies and the recent performance of the index suggest investors have taken note. While dividends remain an important part of utilities' allure, their importance will continue to dim as electric competition looms. Investor response to these changes will determine whether electric stocks power a portfolio higher or cause an investment blackout.

Christopher S. Edmonds is the president of Resource Dynamics, a private financial consulting firm based in Topeka, Kan. At the time of publication, he was long Western Resources, Sourthern Companies and Utilicorp, though positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com.