Often Overlooked, Utility Stocks Show Potential for the ‘90s

Those boring, dull old electric utilities. How did they ever rack up numbers like these:

* Since 1984, the return on the Dow Jones utility average has beaten the average industrial stock (the Standard & Poor’s 500) four out of seven years.

* In the 10 years ended Dec. 31, the average utility stock mutual fund rose 252%, versus 203% for the average general stock fund.

* From 1973 through 1989, the average return on 23 major electric utility stocks was 611%, versus 513% for the S&P; 500, according to Goldman, Sachs & Co.

If it’s boring to beat the market, utilities have indeed been the biggest dullards on Wall Street. By virtue of their handsome dividend payments--and the magic of compounding those dividends over time--utility stocks have beaten many so-called growth stocks over the long haul.

But can the utilities top that act in the ‘90s? That’s a subject of much debate on Wall Street these days.

The last few years haven’t been the happiest for electric utility investors. Stubbornly high long-term interest rates and some ugly industry-wide problems have limited the returns on the stocks. Though some of the stocks surged in 1988 and 1989, declines in 1987, 1990 and so far this year have meant no net price appreciation in many electric issues since 1986.

Take SCEcorp, parent of Southern California Edison, as an example. From 1979 to 1986, the stock moved up consistently each year, from $13.75 to $38.875, a 183% rise.

Today, the stock is at $39.25. That’s up less than 1% from the 1986 peak. You’ve earned a nice annual dividend from SCEcorp--now $2.64 a share, which gives you a yield of 6.7% at the current price--but that’s it.

What’s gone wrong for electric utilities? Interest rates, for one thing. Yields on long-term Treasury bonds have remained mostly in the 8% to 10% range since the mid-1980s after falling sharply in the early 1980s. Because utilities are largely viewed as income investments, they move with bonds: If bond yields fall, more people become interested in utilities’ dividend yields; if bond yields rise, more people move to bonds, forsaking utilities.

Still, utilities have a big advantage over bonds--or they should, anyway--because the utilities can raise their dividends as electricity use rises and revenue grows. Bond interest, by contrast, is set for the life of the bond.

That gets to the root of the utilities’ real problem in the late 1980s: Dividends began to go down instead of up at a shocking number of the companies.

“In the last five years, probably 30% of electric utilities had to cut or omit dividends,” says Greg Johnson, co-manager of the San Mateo, Calif.-based Franklin Utilities stock mutual fund.

The dividend disasters stemmed mostly from power-plant construction projects gone awry, especially nuclear. Cost overruns drained many utilities and enraged state regulators. Also, some utilities diversified into ventures far afield from power generation and stumbled badly.

In the end, thousands of shareholders paid the price--from Public Service New Hampshire in the East to Tucson Electric in Arizona, to name but two firms that slashed dividends. Those debacles made investors skittish about the industry and kept stock prices down.

But now, says Johnson, investors need to realize that the construction problems “are really behind the industry. Dividends aren’t in any real danger anymore.” Indeed, few electric utilities have new plants on the drawing board.

In theory, that should mean they’ll throw off lots of free cash over the next five years, especially as unused plant capacity is tapped.

These are regulated businesses, of course, so shareholders aren’t going to suddenly see a windfall. But James Stratton, manager of the utility-heavy Stratton Monthly Dividend stock fund in Plymouth Meeting, Pa., believes that annual dividend increases by utilities should rise from the 2%-to-3% industry average of the past five years to 4% to 6% over the next five.

If interest rates stabilize or ease over the next few years, Stratton believes that more investors will be lured to utilities by the rising dividends. He thinks that he has a good chance of producing a 13% average annual total return on his fund in the 1990s--a 7% annual dividend yield (the average electric utility stock yield now) plus 6% annual price appreciation--as investors reward the companies for hiking their dividends.

The Stratton fund now yields 7.4% and is up 15% this year, counting dividend plus price appreciation. The fund is 55% invested in electric utilities, 25% in real estate investment trusts and 20% in cash and other securities.

Stratton favors such stable-growth electric utilities as DPL Inc. (Dayton Power & Light in Ohio), Pennsylvania Power & Light and Puget Sound Power in Washington. (See chart.)

Franklin’s Johnson has tilted more in favor of what are viewed as high-quality utilities serving the fastest-growing sections of the country--for example, FPL Group in Florida (parent of Florida Power & Light), SCEcorp and Dominion Resources in Virginia.

Johnson is particularly drawn to utilities that either have forsaken ill-fated diversification moves of the 1980s or that have diversified into areas where management can truly add value--such as SCEcorp’s move into cogeneration plants (which produce two types of useful energy--for example, heat and electricity).

Johnson notes that FPL Group recently disposed of its Colonial Penn life insurance subsidiary, and he views that as a smart decision. “Many of these diversification moves were huge mistakes,” he says.

For aggressive investors, some investment pros believe that the best utility opportunities in the ‘90s will be the most troubled companies of the ‘80s as they rebuild their finances--and their dividends. Many of them, such as Public Service of New Mexico and El Paso Electric, are a long way from restoring their dividends. But Warren Spitz, manager of the Prudential Utility stock fund, owns both, betting on turnarounds.

Spitz reminds investors how stock of New Jersey-based General Public Utilities rocketed from $4 in 1981 to $47 by 1989 as it recovered from the Three Mile Island nuclear plant disaster of 1979. And Spitz believes that GPU still has above-average dividend growth ahead of it, to catch up with other utilities.

One thing you don’t hear a lot of utility-fund managers discussing anymore is the chance of a big merger wave among utilities. Though some certainly will take place in the ‘90s, the recent California state decision against the merger of SCEcorp and San Diego Gas & Electric has reinforced that such unions are far harder to achieve than was once expected.

The bottom line for investors? If utility stocks even come close in the 1990s to matching their average returns of the last 20 years, they’ll put a lot of far-riskier stocks to shame. The utilities’ big cash dividends, compounding over time, provide a much more significant payoff than many investors realize. Especially for investors who can shelter utilities in tax-deferred retirement accounts, those dividends are powerful stuff.

Outside of retirement accounts, utilities may now make a lot of sense for investors who would otherwise choose bonds for the early ‘90s. Remember: If you can earn a 7% yield from a utility stock or stock fund, that’s much better than a money market fund and not much below the yields on Treasury notes and bonds.

And if utility dividend growth returns to the healthy level that some experts foresee, you’ll get the benefit of a rising yield--which bonds can’t provide--and the potential of stock-price appreciation as well.

Utilities: Not So Boring

Though electric utility stocks often are perceived as sluggards-and in many cases, they have been in recent years-overall their total return to investors has beaten the Standard & Poor’s 500 index in four of the past seven years.

Total return (price change plus dividends) In percent S & P 500 Dow utility average * through April 30 Source: S & P, Fidelity Investments

PICKING ELECTRIC UTILITIES

Some money managers’ favorite electric utility stocks for the ‘90s.

52-week Fri. Div. Stock high-low close yield Central & SW 47 1/8-36 5/8 44 3/4 6.5% Dominion Res. 48 7/8-41 3/8 48 1/4 7.1% DPL Inc. 22-17 1/4 21 1/8 7.7% FPL Group 32 1/2-26 1/8 31 1/2 7.6% Gen. Public Utils 49 3/4-38 1/2 46 3/4 5.6% Penn. Power 46 1/8-39 44 3/4 6.9% Puget P&L; 23-18 3/4 22 3/4 7.7% SCEcorp 40-33 1/2 39 1/4 6.7%

All trade on New York Stock Exchange

UTILITY STOCK MUTUAL FUNDS

Here are five well-known stock funds that own mostly utilities. Be sure to ask about any sales charges or redemption fees.

Fund name/ Average total return: phone number 10 yrs. 5 yrs. ’91 Fidelity Select Electric Utils. NA +26% +7% 800-544-6666 Financial Utilities NA +40% +11% 800-525-8085 Franklin Utilities +353% +65% +5% 800-342-5236 Prudential Utility B +423% +90% +8% 800-225-1852 Stratton Mo. Div. +222% +34% +15% 800-634-5726 Avg. utility fund +252% +68% +6% Avg. general stock fund +203% +54% +20%

10-year and 5-year data is through last year.

‘91 data is through May 9.

NA: not available (fund didn’t exist for entire period)

Source: Lipper Analytical Services