Don't forget to add utility funds to your list of the biggest surprises of 2004. Normally the domain of widows and orphans, utility stocks turned into the market's Cinderella story this year, mostly due to Wall Street's newfound respect for dividends. The power of the payout lifted the average utility fund 22% for 2004. That's more than double the S&P 500's gain, and the group is set to finish the year as Morningstar's third-best-performing category, after real estate and energy specialty funds. That's quite a turnaround from 2001 and 2002, when boring old utilities trailed the index by 2 and 6 percentage points, respectively. One company benefiting from the sudden surge in utilities is Cohen & Steers ( CNS), the longtime REIT fund specialist that went public this summer. The asset manager branched out from real estate last spring to launch the ( CSUAX) Cohen & Steers Utility fund under the direction of former Franklin Templeton fund manager Bob Becker. The company could not have picked a better time to jump into a new area. The front-end loaded fund, which was started with $1 million in seed money, now contains over $40 million in assets and is up a healthy 19% since its inception eight months ago. And if the utility sector was warming up already, Monday's $12 merger of Excelon ( EXC) with PSE&G ( PEG) could leave it downright sizzling. TSC recently spoke with Bob Becker to see if he expects utilities' popularity to last through 2005. Cohen & Steers is best known as a top-notch REIT fund shop. How does adding a utilities fund fit into the company's strategy? Offering utility products was another step in offering investors income-oriented investment products. So it fits in quite well with their strategy. Obviously, it has been a great year for everybody involved, so we have been quite pleased. Utility stocks have performed well. Rising interest rates traditionally hurt utilities, because they are big borrowers. If higher rates are indeed on the way in 2005, do you think the party can last? We think utilities will perform well even if the economic recovery is accompanied by higher interest rates. When the group has been in good fundamental health, the stocks have kept pace with the market even during periods of rising rates. There is a common misperception as to how utilities should behave in a rising rate environment. Over the past couple of decades, there were three distinct periods when rates rose and the group suffered: the energy crisis of the 1970s, the onset of deregulation in the early 1990s and during the tech bubble in the late 1990s. Utilities suffered from very industry specific factors during each of these periods. But if you exclude those slightly abnormal periods, utility stocks have kept pace with the market even when rates have risen. OK. I'll buy that. So what kind of returns are we looking at? Assuming no multiple expansion, we think utilities can provide a very attractive return. Long term we expect 3% to 5% from earnings growth and another 4% to 5% from dividends. And best part is that it comes with much less volatility than the broader stock market. A few years ago a number of utilities, TXU (TXU) for example, promised that they would not cut their dividends, and then turned around to chop them soon after. What should investors look for to make sure their dividends are safe? Investors need to look not only at dividend payout ratios, which are the ratio of dividends to earnings, but also at the underlying cash flows produced by the businesses to make sure there is adequate coverage. How do rising oil prices affect utilities?
Very little power is produced using oil as the fuel source. So higher oil prices will have little impact on utilities. Most of the industry produces electricity from coal and nuclear fired facilities, and the prices for those fuels have been much more stable. That also means utilities will see margin expansion because they can raise prices. Have we recovered from the effects of the blackout of 2003? Should I put my flashlight away? There is still a significant need to invest in the transmission grid. We think ultimately that this will lead to higher earnings growth. But there are still issues with the infrastructure and a great need for capital investment. So the situation has not changed greatly. Policy makers have been looking at the problems, but it's going to take some time.
What kind of trends are you seeing in the sector?Constructive regulation has been positive for the sector overall. We expect to see higher expense for environmental compliance over time. But most of the companies can recover these costs through higher rates. Perhaps the biggest problem the industry has faced in recent memory was when a few companies moved away from generating electricity and started energy trading businesses -- to disastrous results, of course. Have we seen the last of that? The theme in the industry has been "back to basics." Managements are refocusing on their core regulated utility franchises. Balance sheets are getting fixed and cash flows are improving. One of the problems of partial deregulation was that dividend payout ratios were cut in favor of investing in noncore businesses. Now these companies are looking to raise their dividends when they can, and investors appreciate that. A lot of companies also tried to expand overseas, once again with an ugly result. Will they try and expand abroad again now that they can use their stock as currency again? We think there is a less of a risk that utility executives will return to their bad habits and start looking for opportunities outside their core competencies and outside the U.S. For the next several years, distributable cash flow is going to go to dividend growth. After you see a period of strong dividend growth you will probably see it go to investment in the transmission grid. Which stocks do you like in particular? We look for utilities that benefit from strong customer and demand growth. Florida Power & Light ( FPL) is a good example. They also have a small unregulated power subsidiary that will benefit from the recovery in the power cycle. We also like Exelon, which is the largest operator of nuclear plants in the country and is seeing fantastic margin expansion. They are showing strong dividend and earnings growth because of an aggressive cost savings program. Beyond that, they are undervalued when compared to the group. How does it feel for people to turn away from sexy things like tech stocks in favor of boring old utilities? We think this is another positive thing for the sector because we don't think investors have really caught on to all the positives going on in the industry. According to a recent Merrill Lynch study, utilities are still the most underowned sector out there. Institutions still don't hold utility shares. Furthermore, they continue to have the highest short interest of any sector in the equity markets, which shows you that there is still negative sentiment toward the sector. We think this will change over time and help the stocks. We also think utilities will also benefit from the country's demographic changes. Baby boomers entering retirement will increasingly demand high dividend yields. Utilities are the highest yielding equity sector that qualifies for the new 15% tax rate on dividends. That's going to be important to folks for a long time to come.