Utility Stock Research

It is time to start researching stocks for the 2010 trust fund recommendations (I recommend six stocks in total, each fund takes two, unless there are some special sells needed or consolidation).  While doing this, I also look for opportunities for myself on occasion, although the vast majority of my personal investments are in passive ETF’s with low costs and CD’s bought through a brokerage (and real estate). This particular post is discussing US utility stocks.

Yield and Interest Income

Right now there is little yield available.  Interest rates in the US are very low and the “risk premium” received for taking on more risk is not high relative to returns.  At one point the risk premium on lower rated debt was very high (in 2008-9 during the height of the fiscal crisis) but now it is only a couple of points over Treasuries for comparable maturities which isn’t worth it, in my opinion.  Per the latest:

• 10 year treasuries 3%
• equivalent corporates 4%
• High yield 7.4%

Basically they are paying you only 1% more than what you’d get risk free for high quality corporates that still have a risk of default and then 4.4% more (pre-tax, meaning after tax about 3% more) for taking higher risk debt.  To put the “absolute” dollar amount in perspective, if you put in $100,000, you’d make $3,000 risk free with CD’s and then you’d make $4,000 with principal risk for corporates, and after tax the difference between the two is even less.  Why bother?

Picking stocks based on dividend yield is risky.  For one thing, stocks with a high yield (> 5%, for instance) tend to be paying out dividends at unsustainable rates, and when the dividend is cut, the stock price tumbles.  Examples of this from my portfolio include GE (since sold) and Nokia (likely soon to be sold).  Stocks with high dividend payouts are often valued by some investors on the stream of income, so that any “hit” to the dividend brings a disproportionate reduction in stock prices.  For other types of investors, dividends are one component of the valuation stream (along with potential appreciation in the stock price itself) so a hit to the dividend, while bad, won’t lead to a price free-fall.

Dividends currently receive a more favorable tax treatment than interest income from a bond.  Bond income is taxed as ordinary income (the highest rates), unless you are buying municipal bonds, which are an entirely different topic.  Dividends are taxed at a lower rate because they are already taxed at the corporate level, so taxing them again heavily when paid to investors essentially amounts to double taxation.  Dividends are currently taxed at 15%, while regular tax rates on interest income can go as high as 35%.  There is a lot of talk about letting these dividend rates lapse for personal taxpayers, however, in 2011 which would significantly reduce the value of these payouts and potentially impact behavior of corporations (who can often choose to do stock buy-backs which don’t have the same tax disadvantages), as well as likely pummeling the value of heavy dividend paying stocks. No one knows what is going to happen with tax policy; as I wrote here NO ONE thought that the US government would let the estate tax totally lapse in 2010, but it did.

Thus while you can view interest bearing bonds and dividend paying stocks as “equivalents” from a yield perspective, the stocks are MUCH more likely to fluctuate in value. Stocks can easily move 3% – 5% in a single day; bonds rarely move that much. Your “yield premium” from investing in a stock vs. a bond could be wiped out in ONE DAY due to a move in the stock price itself. Thus ideally you’d want a decent yield with the hope of price appreciation (or at least only a limited downside on price).

Utility Stocks

One possible substitute for bonds are utility stocks. I did a stock screener at google finance for utility stocks that were paying dividends between 3% and 7% with a reasonable sized market cap of > $1B, and a price / earnings or PE ratio of less than 12. In laymans terms I am looking for stocks paying a high but not unreasonable dividend yield, that were large enough that their stocks would be relatively more stable, and that weren’t over-priced relative to their profitability. Another item I was looking for was a lack of price appreciation over the last year or so; I don’t want to buy a stock that has had a big run up in value if I am looking for a dividend payer.

Out of this list came some reasonable candidates for review (I am excluding the foreign companies), including:

• Ameren
• First Energy
• Exelon
• UniSource Energy
• Public Service Enterprise Group
• Next Era Energy
• Cleco

I will start to review these companies as potential candidates for the stock selection and for maybe my own “yield portfolio” that I’d put some money into relative to CD’s (not a huge percentage, but a decent start).

Some factors I will be looking at, besides the unique characteristics of each company, include the new EPA rule-making authority on emissions, which could require these companies to shutter older coal burning plants or retrofit them with expensive scrubbers, as well as trying to guess on whether the dividend reduction will be repealed.