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Gauging the Utility of Utilities


With strong yields and even stronger returns, analysts analyze the smart picks in the sector.

Truth is, everything about this sector is boring except what counts: the outperformance.

Travis Miller, a senior equity analyst at Morningstar, just this morning released an interesting research report investigating whether there might be any value left in utilities. His conclusion: yes, dear investor, there are still some attractive total-return opportunities left in the sector, along with some areas where he thinks the fundamentals don't justify all the enthusiasm.

Over the past three years, Miller notes, investors have moved hard into utilities as they tried to capture recession-resistant cash flow and attractive dividend yields. A market-capitalization-weighted group of the 34 largest fully-regulated U.S. utilities has outperformed every other sector since October 2007, with an 18% total return through September. Consumer goods, the second-best-performing sector, has produced just 7% total returns, and the S&P 500 has lost 20% during the same period.

Yet, Miller says, utilities still offer a 4.4% average dividend yield. "Compared with the 2.5% current yield on 10-year U.S. Treasury bonds, utility dividends are the most attractive on a relative basis they have been in at least two decades," the analyst emphasizes.

Despite the attractions of the sector, Miller advises stock pickers to choose carefully when hunting for opportunity in this space. A muddle-through economy could stymie energy demand, reduce the need for infrastructure growth, and encourage regulators to cut customer rates -- all limiting dividend growth. Also, if Bill "Bond King" Gross is right, and on the other side of all this monetary stimulus is a new inflation, then both utilities and Treasuries could face lackluster returns.

Miller's favorites right now: Westar (WR), Portland General (POR) and National Grid (NGG). Ones that he argues are looking too richly priced for his money: Piedmont Natural Gas (PNY) and WGL Holdings (WGL).

One popular way for investors to put money to work in the sector has been with the Utilities Select Sector SPDR Fund (XLU), which includes holdings like Duke Energy (DUK), Exelon (EXC), and Public Service Enterprise Group (PEG). However, for traders, a word of caution on this ETF comes from technicians who eyeball the charts and don't like what they see.

Katie Stockton, MKM's chief market technician, points out that the XLU is testing resistance at its late 2009 high, which is a natural place for some consolidation she says. Downside risk appears limited because momentum is healthy and there is support near $31. However, Stockton says that relative strength is not supportive of the XLU versus the SPX so she would be underweight electric utility stocks right here.

Still other market pros we checked in with also like utilities, but prefer to play them with companies that benefit from the ongoing global growth story as opposed to utilities exposed only to a U.S. economy that continues to just plod along.

"I like the global utility arena as opposed to domestic U.S.," says Vinny Catalano, president and chief investment strategist with Blue Marble Research. "That is where the growth is. China and other emerging markets need to ramp up their electric power capability."

Catalano tells us that he plays the theme with iShares S&P Global Utilities (JXI). "The growth potential is definitely there," he says.

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No positions in stocks mentioned.
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