Cheap Utility Funds That Pay Rich Dividends

NEW YORK ( TheStreet) -- Shares of power producers have been ice-cold lately. Mutual funds that invest in utilities have returned 0.4% this year, lagging the S&P 500 Index by 8 percentage points. The fund group ranks dead last among the 21 domestic equity categories tracked by Morningstar ( MORN).

The slow going can be traced partly to the mood of the market. Since stocks hit bottom in 2009, investors have preferred shaky companies that once seemed about to collapse. Rock-solid electric and gas producers have attracted little interest.

Utilities have also been held back by uncertainty surrounding tax rates. If Congress does nothing, cuts passed under the Bush administration will expire. Dividends will be taxed as ordinary income, and the maximum rate on dividend income will climb from 15% up to 39.1%. That would be a blow to utilities stocks, which are prized for their high dividends.

Should you steer away from utilities? Maybe not. Based on dividend yields, utilities could be attractively priced. Traditionally utilities deliver about 90% of the yield of the 10-year Treasury. But now that utilities share prices have lagged, their yields have become relatively rich. The yield on the Utilities Select Sector SPDR exchange-traded fund ( XLU) is 4.24%, well above the Treasury yield of 3.66%. "Historically you did well if you bought utilities whenever they yielded more than the 10-year Treasury," says John Kohli, portfolio manager of the Franklin Utilities Fund ( FKUTX).

For long-term investors, utilities funds can help diversify portfolios. Supported by the hefty dividend yields, utilities funds tend to hold up in market downturns. When markets collapsed in 2008, many utilities funds outperformed the S&P 500 by wide margins.

Utilities managers follow a variety of strategies. Cautious funds stick with regulated utilities that pay reliable dividends. Aggressive choices buy a range of stocks, including unregulated energy companies and fast-growing cellular businesses.

Among the most conservative funds is the Franklin Utilities Fund. Manager John Kohli focuses on regulated electric and gas utilities. Because of its caution, the fund tends to lag in bull markets, but it excels during downturns. Limiting losses, the fund has returned 7.9% annually during the past 10 years, outdoing 98% of its competitors.

These days Kohli is particularly keen on California utilities, including Sempra Energy ( SRE), which operates San Diego Gas & Electric, and PG&E ( PCG), a power producer based in San Francisco. Kohli says the companies will benefit from California's drive to build more efficient transmission systems as well as increase solar and wind power. To encourage more use of alternative energy, regulators are permitting the state's utilities to invest in green power -- and pass along the cost to customers.

That will result in growing revenues, and Kohli figures that the companies can increase their profits at annual rates of 8% to 10% for the next few years. He says that's attractive growth at a time when overall corporate profits may only grow at a 6% rate.

Investors who want some zip should try the MFS Utilities Fund ( MMUFX), which has returned 5.5% annually during the past 10 years, outdoing 81% of competitors. Manager Maura Shaughnessy holds some regulated utilities, but mostly she prefers more aggressive choices. The portfolio includes unregulated power producers, which sell electricity at whatever prices the market will bear. To find the fastest growth, she often owns overseas stocks. The fund currently has 8% of assets in Latin America and 5% in Africa and the Middle East.

A growing holding is Cellcom Israel ( CEL), the country's dominant cellular provider. The stock pays a dividend yield of 8%. Another holding is Virgin Media ( VMED), which provides cellular and cable TV service in the U.K.

To hold a broad collection of regulated and unregulated companies, consider the Evergreen Utility & Telecom Fund ( EVAUX), which has returned 3.2% annually during the past 10 years. Portfolio manager Timothy O'Brien varies the mix depending on his outlook for the different sectors.

At the moment his is underweighting unregulated companies. Their problem is connected to natural gas prices, which have become depressed because of increased supplies and sluggish demand. Electricity prices tend to rise and fall along with prices of natural gas, which powers many plants. When natural gas falls, unregulated power producers must lower their electric prices and suffer weaker profit margins, says O'Brien.

Seeking a better earnings story, he owns CMS Energy ( CMS), a Michigan power producer. The company is spending heavily on capital improvements that should result in higher revenues and annual earnings growth of 7% over the next five years, says O'Brien. He figures that the dividend should increase at a 10% annual rate. "With the dividend and earnings growth, the stock should do better than the utility industry average," says O'Brien.

He also likes Northeast Utilities ( NU), a regulated company that buys power and distributes it to customers in New England. O'Brien estimates that the earnings can grow at a 7% rate.

-- Reported by Stan Luxenberg in New York.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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