If you fell asleep when the

Nasdaq

hit 5000, woke up today to find it under 3000 and heard everyone talking about utility stocks, you'd probably think you were having a nightmare.

Well, Rip, pinch yourself, because it's all true. Obviously the focus is on California's power debacle -- Silicon Valley types carrying oil lamps to work makes great copy -- but there's a bigger issue. Over the past few years we haven't been building many power plants, but now it looks like this digital economy of ours is sucking up more power than we expected. Now we need more and higher-quality power. But it takes years to build new power plants. So thanks to deregulation, the utilities sector could be an intriguing area as shops sell each other power and compete for one another's customers.

Managers: Bill Reaves and Mark Luftig

Fund: Strong American Utilities Fund

Managed since: July 1993 (inception)

Assets: $27 billion

3-year annualized return/ranking vs. peers: 13.8%/Beats 66% of peers

Expense ratio/avg. utilities fund expenses: 1%/1.43%

Top three holdings:
Dominion Resources
FirstEnergy
Teco Energy

Enter Bill Reaves and Mark Luftig, who have focused strictly on utilities in running the

(SAMUX)

Strong American Utilities fund since 1993. They're conservative types who think this California mess might be giving brave investors the chance to buy some solid companies at bargain prices. What do they like? Will we be living by candlelight, and what about fuel cells and these energy tech ideas we're all so gaga for? Read on.

1. What's getting a lot of ink right now is the situation out in California. That's been pretty troubling to a lot of folks and taken down a lot of utilities stocks. What's going on out there, and what does it mean to investors?

Luftig:

The first thing to realize is that the California situation is an anomaly. It's not going to spread to other states. What you have in California is really two problems that came together, I think, at the same time.

First is a shortage of power, and that has nothing to do with deregulation. It had to do with environmentalists and politicians making it very difficult and very expensive to build plants in California. And so Californians, for a long time, were relying on imported power, power from the north and power from Arizona. The lines coming in didn't increase, but the population and usage in California were growing at a very rapid rate.

And then on top of everything, this past winter you had a decrease in the availability of hydropower from the north, so you had these power-short problems.

The other problem is the deregulation system that they put together out there was unique. It basically forced the utilities -- they didn't put it in so many words, it just made in uneconomic for the utilities to continue their own generation, so they sold off most of their generation. They were required to buy power in the spot market, they couldn't enter into long-term contracts, and they had to resell it at a fixed rate.

Sounds like a recipe for disaster.

Luftig:

Exactly. And nobody figured that the price of gas and oil would fly up the way it did. So they were paying much higher rates, and the customers weren't feeling higher rates, they were getting served at the fixed rate, so there was no incentive for them to conserve, no price signals going there. No place else do we have these problems.

Reaves:

There might be other places where you do have set prices for certain periods of time. But most of those have fuel-adjustment clauses, or the companies have plenty of generating capacity so it's not much of a problem. or they are heavy in coal generation and nuclear generation, so that they aren't seeing that as being too much of a problem.

Luftig:

No place else were the utilities -- and in California, it's been alleviated now -- required to buy 100% of their power in short-term markets. It didn't make any sense. Not only that, the way the bidding was, it was a Dutch auction, so that everybody like in the U.K., everybody was getting paid the highest accepted bid.

Essentially, they set up this system and there's a kind of a transition period during which there is not full competition, but these fixed rates. And once they get past this, then it's supposed to be market-based rates, and in the meantime, the California companies kind of get caught.

2. In light of this, what areas of the utilities market look most promising to you going forward, and what areas might you stay away from?

Luftig:

Well, the electric industry where we stand right now is back to 12 times next year's earnings. And fundamentally, except for California, nothing has changed, at least from a few weeks ago. And we see, it shouldn't be all that difficult for the industry to get the 14 times earnings which would still be more than a 30% discount to the S&P.

Within the industry, we prefer that the people are into generation rather than just entirely local distribution. And particularly those companies that are integrated electric and gas operations, where they have the ability to arbitrage fuels, to sell gas. Bill, did you want to talk about the gas?

Reaves:

Well, let's keep talking about this a little bit. You could say only half of the states have enacted restructuring/deregulation legislation, and there are differences. Some of them are very good; indeed, some of them are just OK. All of them are essentially allowing some recovery of stranded costs.

But some states had enough foresight to set up a transition process that will put their company and companies under their regulation in an advantaged position as they move into full competition two, three, four, five, six years from now.

So obviously it's better to be with a company that's going to be in that position than other companies. And what you have is, the electric and gas industries are converging. You put the two together, and you're talking a $300 billion annual type of business. There are significant changes in the way that energy and utility services are being packaged and marketed, and a lot of that business is not going to be regulated as to rate of return. So the companies that are capable of capturing these opportunities stand to grow stockholder value very impressively.

Particularly in the second half of last year, you could see some recognition of that coming into the market, and you could see some discrimination coming into the market.

A company like

Duke Energy

(DUK) - Get Report

was recognized as being a likely winner. And that moved up from roughly 12 times earnings to at one time as high as about 21 times earnings. It's selling at about 16, and a small fraction times 2001 earnings, and probably about 14.5 to 15 times estimated 2002 earnings.

Any other companies that stand out to you?

Reaves:

Dominion Resources

(D) - Get Report

.

Last year, the standard for companies that weren't well positioned to prosper in the climate ahead, the standard projected earnings outlook became 8% to 10%. That was just last year. Then, recently, Duke Energy raised the bar on that by declaring earnings to be 10% to 15%. And Dominion Resources recently just a few days ago, provided three-year earnings guidance to about 15% compounding per year.

The decline in prices caused by the dumping is a tremendous opportunity. When we say recognize quality of premium type companies in the electric area, it's a 20%-25% discount to the market in stocks that we would expect to become recognized at close to 50% discount. So there's room for major price-to-earnings-multiple expansion there.

3. On the flip side, if there are winners there are obviously losers. What companies do you see in a less enviable position?

Reaves:

For a while, going back a year or two ago, the deal was to sort of find inept companies that had to be taken over because they weren't going to make it, and so other companies would pay a premium to buy them. We've never played that game because we hate to be associated with any of those companies. The danger would be to over-stay, because once you get through the transition process, and as the various states establish what the rules are going to be, and as competition comes into the picture, the good companies are going to take the inept companies' lunch. So, instead of acquiring them, it's better to take the customers, their most desirable customers.

Luftig:

We'd rather not go in print pointing out names of companies we don't particularly care for.

Right. For an investor, though, what are the flags they can use to find if a company is well positioned or not?

Luftig:

Well, management is one important thing. It's not that easy, you've got to do your research.

If you're going to go out and try to pick stocks on your own, you're best off identifying with quality companies rather than something that looks particularly cheap, because there tends not to be enough of a difference to make it pay. You should also not just buy one stock; you should try to diversify into different regulatory environments, in different parts of the country, different fuel mixes.

4. Some folks say that as tech melted down last year, a lot of institutional money and investors went almost blindly into more defensive areas -- pharmaceuticals and utilities and financials. They think that that was part of utilities having a nice year last year. Do you think that, in a way, that could hold the sector back, that maybe there are a lot of people owning the stocks out there who didn't buy them on a fundamental basis?

Reaves:

And those people probably never did take the time to understand how good the outlook is, they got in, they served the purpose, and they dumped them over the last couple of weeks.

I think most of that has now been expressed. I think that there's a very solid level of demand for the stocks. It can look overwhelming any given day or any given week when stocks are being dumped.

One of the stock in our portfolio worth mentioning is

FirstEnergy

(FE) - Get Report

. Ohio is one state that has done its deregulating/restructuring legislation. The Utilities Commission has put it into practice, you know what the ground rules are. This is a company that has a very good outlook and essentially is on the record in the stock market as to how good their outlook is.

One of the reasons it's being held back is they are acquiring a company called GBU. It could be July or August before the deal is completed. That always puts a little pressure on the stock. But we think the outlook is very solid.

5. A couple stocks that a lot of portfolio managers have been talking to me about are Calpine (CPN) and Enron (ENE) . There seems to be just sort of a buzz around those two names. What do you folks think of them?

Reaves:

We've had really good positions in Enron, Dynergy,

El Paso

(EPG)

and

AES

(AES) - Get Report

. We never had Calpine.

At one time, Enron was the biggest stock in our portfolio. It was probably about 8% to 8.5% weighting and it had a big move. We feel a utility portfolio is one that investors expect to get good downside protection over market cycles, and so when we got price spikes we would cut it back.

I don't know how big a weighting in the portfolio we could have in a company that is like 50 times next year's earnings. You'll find our portfolios have a long-term record of being extremely good in bad markets.

Luftig:

We think, basically, Enron's an excellent company; they're very sharp in what they're doing. The only hesitation that we have on owning more than we have is the price.

What do you make of their efforts to kind of branch into bandwidth?

Reaves:

Oh, they probably can do it, they're pretty smart.

Luftig:

They haven't broken even on it yet, but that's clearly the next step for a lot of people. If anybody can succeed at it, we think they've got the best shot. They've got this major strategy of reducing assets. They started a few years ago, feeling they needed to own assets behind the trading. And now they're managing to do it with less and less assets that are owned, although they have the power under control, and so their returns on assets or returns on equity are very high.

Regarding Calpine and the independent power producers, what's your take? There's obviously a big buzz around these folks, on both sides of the equation.

Luftig:

There's a lot more risk in all of them than owning a utility.

Why is that?

Luftig:

Basically, a number of them are going into business without any customers.

Reaves:

We don't think that becoming a merchant generator -- selling into the wholesale market only -- is going to be long term a really great business. It's going to be a risky and volatile earnings business. A company that is in that business, and has a really good marketing strategy, could be quite good.

Luftig:

It's like being in the refining business. The plant is nailed to the ground. And you get subject to the vagaries of over/under capacity.

Now is that why Duke Energy is interesting, because they have customers but they're also in the wholesale market?

Reaves:

Also, they're taking on solid long-term customers outside their territory and that's on a completely nonregulated basis. And they're providing major services to many of them.

Luftig:

And they've got engineering, they've got field services, they've got energy services and they cover a broad area.

6. How long do you think this California cloud is going to hang over the sector, and does it create an intriguing entry point?

Reaves:

I think it's one of the best entry points I've seen in years.

Luftig:

I think we're talking about months rather than years. I think you can go back in history and kind of look at kind prices situations and how they worked themselves out. I'm talking about you can go back to 1974 or 1975, with the Arab oil embargo and Con Ed went down to $3 a share, and missed a dividend from one quarter, but it came back and the rest of the industry started to come back.

When you had the accident at Three Mile Island, the whole industry went down in the period of a couple of months. It's back up again, and I think either one of two things could happen with California.

One, I think a lot of utilities and a lot of regulators would like to make it clear that their states are different than California in terms of power supply, and in terms of regulation process. In fact the chairman of the Pennsylvania Public Utilities Commission just made a major statement to that effect, that his state was very different from California.

Second, I think, in the near term -- weeks rather than months -- there's going to be some plan put together in California to work things out. It doesn't mean that the California utilities are going to come out healthy, but there'll be a plan put down where everybody's going to see what's going to get done.

I think it's going to involve, probably the sale of their hydroelectric facilities, and using proceeds from that to give them cash. Maybe some bond issues and other things, but it's not in anybody's best interests to drag this out.

Right. Some people are saying it may become an issue that starts to stunt economic growth in California -- when say, Intel decides they're not going to build a plant there.

Reaves:

Of course. If it affects California, it can affect the growth of this whole country.

Luftig:

But you'd be kind of foolish today to build a plant in California, and rely on highly reliable electric utility service, if you needed it. And what I mean by that is, Intel, for example, they talk about power interruptions in nanoseconds. To them, being down for two seconds is critical.

If they're going to build a plant there, they have to put their own generation. And that's doable today, by the way.

7. Oh, yeah. Actually, one point I'd like to discuss is how the whole idea of all these server farms connect to this. The Intels and semiconductor shops, they need uninterruptible power. And that seems like it's just going to be a huge business, because it has become a necessity. Who benefits there?

Reaves:

One of the things you're going to find is customers that have that critical need are going to be willing to pay. They now know what it means, and they're going to be willing to pay for higher-quality service.

Luftig:

Remember now as you go toward deregulation, you don't have to have a service where one size fits all. Now companies come in and offer a server farm, for example, and we'll provide you with power from some generating plants, but we will have onsite miniturbines that'll immediately kick in. We'll provide you with lines with multiple sources.

Who makes these kinds of miniature power generators that they could see sort of ramp up in their sales?

Luftig:

Capstone

(CPST) - Get Report

is one; there are a number of companies working on these things now. They're mostly in beta testing.

Everybody now is talking about alternative energy and new technologies to provide uninterruptible power and just store power for folks. People talk about these smaller turbines; they talk about fuel cells. What are the main technologies that are out there and just in sort of layman's terms, how do they work?

Luftig:

Well, there are many turbines.

They're just a small power plant.

Luftig:

A small power plant. There's a fuel cell. That's a chemical process and there could be a lot of different feed stocks, but the most likely one in this country is natural gas. It works very similar to a battery, except you keep feeding in natural gas and it regenerates. I think those are the two that are closest.

There are areas in California and some other places where they're doing wind. And a couple areas in California where they're using geothermal.

What is geothermal?

Luftig:

Geothermal is using the heat from volcanic formations, down a couple of hundred feet. And in certain places you can drill down and get a lot of steam, run those through turbines. Other than fuel cells, almost everything involves turning a turbine. Whether it's a nuclear plant, or a gas fire plant or a coal plant, it's basically heating water and making steam.

8. How far are fuel-cell companies from getting to the market and making money? In terms of the whole spectrum of alternative energy, what do you see as being the most solid companies, this early on?

Luftig:

I think the miniturbines are the ones that are closest to being marketable at this point, and they work. The only problem is, right now, the cost of running them in most cases is higher than what you could buy power for.

But utilities can use them in certain places, where they have transmission problems and people that need highly reliable power can put them on for a portion of their assembly line or something else. You don't have to put everything on the miniturbine.

Fuel cells are probably around five years away, at the earliest.

In a way, talking about these companies feels like we're talking about biotech companies, in that you've got this sort of whiz-bang idea, but you don't know if it's going to work.

Luftig:

They work. The problem right now is the economics. Technically, they work. The problem is that they haven't figured out yet how to make them cheaper now so that they can compete with standard sources. And eventually, it's probably going to get there. The other thing is that it's very difficult to build major transmission lines today. It's probably more difficult than if you had started a new nuclear plant, because you go through a lot of people's back yards, and they don't like the idea.

What companies stand out to you in the alternative space as having the best sort of technology management marketability?

Reaves:

Capstone is the one that we would feel by far the best about. They're the closest, they've got something awfully, awfully good, it essentially breaks the mold. They are in the phase of rapidly increasing the manufacturing of actual units and sending them out.

Luftig:

On fuel cells, we don't invest in these companies. Fuel cells, I don't really know. There's been a few of them out there, we mentioned the names, and one's as good of a bet as another.

You stay out of this area basically because of the risk side, right?

Luftig:

Yeah. I mean, they're not utility.

In terms of the distributive model, what companies would benefit from that trend?

Luftig:

Well, the big one on a 250-megawatt generator is

GE

(GE) - Get Report

. But it's not a big enough part of their business to make any difference in terms of investing in the stock.

Reaves:

A utility company such as

DTE

(DTE) - Get Report

may very well be able to benefit from the move towards distributive generation.

9. Within utilities, some funds load up on telecommunications and others do not. Some people think the lines for these funds have to be redrawn because, technically, you can look at Morningstar and it looks like the average utilities fund might have just about half their money in actual "utilities" sector. What's your take on that situation? A lot of people say loading up on telecommunications is kind of cheating for a utilities fund. If you look at 1999, the top utilities funds had Qualcomm in the top holdings.

Reaves:

I never really owned that.

Luftig:

I'm not criticizing people who do it, but I think you need to know what you're buying when you buy a fund. It's our belief that the way we're running this fund is a conservative fund for conservative investors.

We're not out there trying to buy growth stocks, particularly when the growth is coming from manufacturing equipment, and not from the utility business. As a result, if you look at our relative performance, 1999 was not such a great year but 2000 was. And that's the reason, it's because we're in utility. As Bill said, we own telephones, but our telephones are real telephone companies.

Reaves:

There were times in the past we've had 35% or more of our portfolio telephones. As of yesterday, in the Strong Fund, it's now down to 10.7%. We made a major reduction in January 1999 and there have been some further reductions in that, and it really had to do with extremely interesting opportunities, you know there was a shot at buying Dynergy before it was really discovered, and people caught on to how good the outlook was.

As of right now, as of yesterday, in the Strong American Utilities Fund, 41.9% of the portfolio is in electric utility stocks, about 18.8% is in gas utility stocks. We have a strange sort of thing in there in that we use very large energy companies such as Exxon and Enron and that type of company, companies that raise the dividend regularly and have an essential small unit price of product, for the most part.

10. If you had to buy three stocks and hold them for five years, what would they be and why?

Luftig:

It's probably an unreasonably long investment horizon today in the utilities, because the style changes. They come and go. You're much better off investing in a fund than you are in picking three individual stocks that you think you're going to hold for five years.

Having said that, there are stocks in our fund that we've had since day one.

Reaves:

Enron, quite probably, is a stock to own that way. But you have to understand that the price is such that at any given time, they could just have a hiccup, and just a quarterly problem and the stock could drop 15% to 20% on you.

It's something you have to live with, but let the value build up over a period of time and it's pretty darned impressive. And so you really have to grit your teeth during the bad times.

I certainly think Duke Energy is one that if you set those parameters, it's highly likely to be one of the major winners. In particular, as of right now, it's selling about 14-14.5 times 2002 earnings. That's getting down to a pretty reasonable thing for a company that's being recognized and it has the elements in the management to execute.

Luftig:

If you were going to own three, probably the third one would be a telephone company, if you're going to go out five years.

Reaves:

SBC

(SBC)

we think is probably the one that's going to make it pretty well.

Fund Junkie runs every Monday, Wednesday and Friday, as well as occasional dispatches. Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.