Investing in Utility Stocks

Investors in utility stocks enjoyed terrific returns in 2011.

The sector provided the best returns in the S&P 500 last year, gaining almost +15% in price and a total return of nearly +20%, according to Merrill Lynch.

Utilities offer investors two major attractions:  high dividend yield and stable business models. 

Despite last year's strong run, the dividend yield of the utility group is still nearly 4%, or more than double the yield of the 10-year Treasury note.

The economy may expand or wane; the Fed may or may not act; and the euro may or may not survive;  but we will all turn on the lights and heat our homes and offices.

However, utilities now sport the second highest P/E ratio in the S&P, and many strategists are suggesting that the group may lag the broader market averages in 2012.

I had the chance to hear the thoughts of Dan Ford of Barclays Capital yesterday. Dan has been following the utility sector for a number of years, and is, in my opinion, one of the top utility analysts around.

Dan still likes his group, even at these valuations.  He notes that dividends remain very popular with investors. Growth & Income mutual funds have been receiving large inflows of cash, and these funds typically have been large buyers of utility stocks.  Finally, with the Fed due to keep interest rates low for another two years, high dividend yields from "boring" utility stocks should continue to be popular.

Still, Dan urged more selectivity in utility investing in 2012.  The largest regulated utility stocks (such as the Southern Company) are already trading at record P/E multiples, and offer less attraction than some of the smaller utility names, in Dan's opinion.  He likes such stocks as CMS Energy and Edison International, which are less widely followed but are solid franchises.

My question to Dan concerned rate cases.  With interest rates so low, and the economy still struggling, will regulators continue to grant rate cases to their utilities that allow returns of 10% to 12%?

Dan thinks they will.  He notes that most of the rate increases are still modest, and mostly related to infrastructure improvement.  His team went back more than 30 years, and have found almost no cases of regulators reducing allowable rates of return simply because of the prevailing interest rates.

The risks to the group this year mostly relate to interest rates.  While most - including me - believe that interest rates will remain stubbornly low in 2012, a sudden rise in interest rates could negatively impact the group.  Regulated utility returns have historically been very closely tied to interest rates, so a change in the credit markets could hit the group hard.

In other words, utility stocks remain a reasonable investment for this year.