Why Utilities Are Set to Repeat History and Offer Enormous Gains

In late December 2002, the “dot com” bust was complete and the market was about to close the books on its third straight losing year. Bargains were plentiful and the economy was pulling out of a recession, but investors had had enough and many wanted nothing to do with stocks of any kind.

That distaste even included utility stocks, which for decades were considered to be among the market’s most conservative. But the fall of Enron had unfairly tarnished the entire group, and between 2001 and 2002 many utilities lost more than half their value.

Over that time, investors would yank approximately $13 billion out of utility funds.

But that shortsighted decision would prove costly, as the deeply oversold group came racing back. In fact, the Dow Jones U.S. Utility Index rebounded +24% in 2003 and would post five consecutive years of healthy double-digit gains — giving investors a whopping +145% cumulative return for the period.

That streak came to an end in 2008, with frightened investors dumping high-quality utility stocks much like they did back in 2002. But once again the stage is set for a powerful comeback. And contrarians who take an interest while the sector is still out of favor could rake in handsome gains should history repeat itself.

Once referred to as “widow and orphan” stocks, regulated utility providers are still highly prized for their predictable cash flows and enticing yields. Of course, the trade-off is that growth can sometimes be hard to come by. That’s why many utilities give most of their earnings right back to shareholders rather than reinvest it back in the business.

But as we saw from 2003-2007, even the stodgiest of utility stocks can deliver outsized gains when the price is right and valuations are too compressed. In the meantime, the sector’s stout defensive characteristics are more appealing than ever in this chaotic market.

Though deregulation has changed the playing field, many utilities remain recession-resistant and free from the issues that other companies are grappling with. Retail sales may be down, banks could have trouble collecting credit card debt, and hotel rooms might be vacant. But homeowners aren’t cutting back on basic services like gas or electricity — nor can they switch to another provider.

You probably send a check every month to the companies that transmit power, gas and water into your home, as do thousands of your neighbors. I just sent CenterPoint Energy (NYSE: CNP) a payment of $46.82 for my June gas bill. And that check is just one of about five million the company deposited from its huge base of residential and commercial customers. The beauty is that all that cash pours in each month regardless of which direction the economic winds are blowing.

Because they are closely monitored by government regulators, utilities are often free from widespread competition and enjoy a dominant (if not monopolistic) hold over their market. Plus, most are allowed to set rates at fixed levels that represent a fair profit margin over their cost of capital and can increase prices to adjust for inflation.

Some can even pass along rising expenses directly to customers, whereas other industries simply absorb them and watch their profit margins shrink. Not surprisingly, most utilities generate buckets of highly predictable cash flow and make rich dividend payments to shareholders. It’s not uncommon for a utility to distribute 50-75% or so of its earnings and offer a hefty yield above 5%.

And the more this economic trough deepens, the brighter those defensive traits shine. To preserve cash, companies have been forced to axe their dividend payments left and right. Remarkably, the group as a whole has actually boosted distributions more than 20 times in 2008– music to the ears of income investors.

When analyzing funds in this sector, keep in mind that utilities are not all created equal. Some generate power with coal-fired facilities (that may come under pressure from a stringent Obama carbon “cap and trade” system), while others rely on wind or cost-efficient nuclear generating assets. Some regulated markets are far more business-friendly and open to rate hikes than others.

Business models can also range from the conservative to the aggressive. One regional utility might focus on transmission and distribution, while another supplements growth with unregulated power merchant activities — generating and selling electricity on the open wholesale market. Generally speaking, companies that are heavily engaged in unregulated activities carry more risk, but also more upside potential.

In any case, utility stocks have historically offered some degree of insulation from market volatility, but they haven’t been spared this time around. In fact, the Dow Jones U.S. Utilities Index has retreated around -35% in 2009 — underscoring the fact that nobody has escaped this market turmoil.

Some traders have pinned the selling on fears that a global recession will dampen demand. But again, residential use isn’t economically sensitive and few homeowners would consider their utilities to be discretionary. As for large industrial users, many of these customers have committed to long-term contracts and will continue to pay fixed rates even if their consumption drops.

Meanwhile, others point to the frozen credit markets as being a near-term obstacle for utilities needing to tap the capital markets. But the financial crisis appears to be easing and should be less of a concern going forward. This is important, because increased spending paves the way for higher earnings.

We’ve talked extensively about the need for advanced water treatment facilities, new power generating assets, more reliable transmission lines and other such projects. Whether it’s upgrading outdated equipment or adopting cleaner alternative energy sources, both developed and emerging countries will be forking over trillions in infrastructure spending.

The good news is that investments made to expand a utility’s rate base (pipelines, plants, storage facilities and other assets) lead directly to stronger earnings — and thus rising dividend payments.

The immediate outlook for the utility sector has a few question marks, not the least of which is the fact that borrowing costs have increased by several hundred basis points.

But regulated companies still have highly visible cash flow prospects and look attractive in these cloudy economic conditions. Meanwhile, power merchants are likely to benefit if commodity prices rebound (which tend to raise electricity costs and boost margins) and should offer an element of growth.