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Utilities: A Surge or Sustainable Power?

If the 10% returns from real estate stocks mentioned in my

earlier column aren't enough to get you excited, this may come as a shock: Since January, utilities have gained nearly 15%, outperforming the

S&P 500

by more than 10% and the

Nasdaq Composite

by almost 25%. Like REITs, utilities have significantly underperformed the tech-laden Nasdaq in the past year, but have inched ahead of the S&P 500.

Utilities Outshine the Averages

Dow Jones Utility Average vs. the Averages

For analysts who have suffered through the "lights-out" period, the move is both refreshing and surreal. "It scares me a bit," quips

Donaldson Lufkin & Jenrette

utility analyst Jay Dobson. "It can't go on like this forever."

Analysts think the rally is supported by fundamentals and investors' desire for companies with solid earnings. "Many utilities have developed solid business plans with good growth prospects," says

First Union

analyst Tom Hamlin. "Earnings growth should be 8% to 10%, so you get three-quarters of the growth of the S&P for half the price. Throw in a yield five times greater than the S&P and I guess you call that value."

Holding current levels is one thing, gaining additional ground is quite another. Electric utilities are trading at about 12 times this year's earnings, which is just below the industry's historic multiple. And the average dividend relative to bonds has found its sweet spot. "The dividend spread is about 95 basis points

under the 10-year

bond, which is historically fair," says Dobson. "Any more than that will probably be given back at some point."

TheStreet Recommends

Hence, Dobson says to pick your spots carefully. First Union's Hamlin urges investors to focus on utilities that have developed solid, integrated business plans that are "already operating in a deregulated environment." His top pick is

Duke Energy

(DUK) - Get Duke Energy Corporation Report

. He also says

Dominion Resources

(D) - Get Dominion Energy Inc Report

and

Constellation Energy

(CEG)

fit the bill and rates both a strong buy. First Union has recently provided banking services to all.

Dobson said utilities with solid earnings growth and those with event-driven catalysts are the best bet. He rates Constellation his top pick. He also likes

PECO Energy

(PE) - Get Parsley Energy, Inc. Class A Report

and its pending merger with

Unicom

(UCM)

, as well as Duke and

FPL Group

(FPL) - Get First Trust New Opportunities MLP & Energy Fund Report

, rating PECO and FPL group a buy. DLJ has not provided banking services to any of the companies mentioned.

One hedge fund manager takes a more discouraging view, suggesting the recent rally has been driven by short covering. "I haven't seen much new money coming into the sector," he says. "All of the traders I've talked to say they've seen little real buying and a lot of shorts closing positions."

He says a number of larger utilities have experienced unsustainable gains and lists

AEP Corp.

(AEP) - Get American Electric Power Company, Inc. Report

,

Ameren

(AEE) - Get Ameren Corporation Report

,

Cinergy

(CIN)

,

Consolidated Edison

(ED) - Get Consolidated Edison, Inc. Report

and

PG&E Corp.

(PCG) - Get PG&E Corporation Report

as companies poised to lose ground when the rally loses power.

While cautious about the future, most analysts are content to enjoy the long-awaited present. "This may be our 15 minutes," says First Union's Hamlin. "It may be difficult when the alarm goes off and we all wake up, but I'll enjoy for now."

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds was long PECO Energy, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com .