Electric utilities may turn out to be this summer's biggest sleeper stocks.
Once shunned as "widows and orphan" stocks, for their consistent, high dividends and humdrum prices, electric utilities recently have gained respectability among value investors as their prices have fallen to historic lows. They recently traded about 12.4 times expected 1995 earnings, while the Standard & Poor's industrials are trading at more than 17 times expected earnings.
What's more, the group stands to benefit if long-term interest rates fall further this year, as some investors predict. Utilities tend to trade like bonds because of their high dividend payout and, like bonds, rise when interest rates fall. Traditionally, for every 100 basis points of movement in long-term interest rates, utility stocks move 12% in the opposite direction.
In addition, dividend yields on electric utilities now are a rich 6.42%, compared with the scrawny 2.02% yield on the Standard & Poor's basket of 400 industrial stocks.
"They (electric utility stocks) are ready to take off for higher levels," said Thomas E. Hamlin, a securities analyst at Wheat First Butcher Singer in Richmond, Va. He expects interest rates on long-term bonds to drop to 6.25% by year end from around 6.7% now. "Investors should be much more positive on the industry," he says.
Then too, the sizzling summer temperatures and the unprecedented demand for power, while discounted by investors as short-term gains that could be blown away by milder weather in the fall, might help some utilities convince state regulators to let them charge consumers higher rates to pay off earlier investments in new plants.
Moreover, Chris Wiles, a portfolio manager at Federated Investors in Pittsburgh, said it is only a matter of time before investors who have made a killing in technology stocks flee if that group's fortunes decline.
"They haven't started to come in yet, but if technology starts to correct, I think you will see a lot of money flooding into utilities because of the cheap valuation of the group," predicted Mr. Wiles, who runs the $752 million Fortress Utility Fund and the $862 million Liberty Utility Fund.
In fact, Mr. Wiles has increased the weighting of electric stocks in the funds to 40%, slightly above the 38% weighting in the S&P utilities index.
Investors have discounted electric utility stocks because of incipient competitive pressures, yet they still are investing in telephone stocks, despite the bigger challenges those shares face from deregulation, pointed out Jack Ryan, senior vice president at Wellington Management Co., and portfolio manager of the $650 million Vanguard Utilities Income Fund.
"It makes sense to sell telephone stocks and re-invest in electric utilities because on the whole they are more attractive," Mr. Ryan said.
Others are not so convinced.
Jim Weiss, chief investment officer of IDS Equity Advisors, Minneapolis, which manages $6 billion in institutional money, said the industry's outlook is murky because of the specter of deregulation and because of fierce, new competition. Mr. Weiss has steered clear of the sector for a few years, but said his company has two analysts studying the sector and is ready to jump back in just as soon as the winners and losers become apparent.
Already, federal regulators have allowed utilities to buy power from competitors and then resell it to their own customers, setting the stage for businesses and residential customers to one day choose from which company they want to buy electricity. And in some states, such as Michigan and Georgia, industrial users of energy already can make that choice.
As a result, a number of electric utilities have entered into marriages of convenience with competitors to expand their markets and become more efficient, lower-cost producers.
In the latest wave of utility mergers, the Public Service Co. of Colorado and Southwestern Public Service Co. agreed to a merger that will create the nation's 25th largest investor-owned utility. Also, Philadelphia-based PECO Energy Co. was rebuffed in its hostile bid for neighboring PP&L Resources Inc.
U.S. utility companies also are going overseas. Two Houston utilities - Central & South West Corp. and Houston Industries - are considering a white knight bid for NORWEB PLC, a Manchester, England, regional electricity supplier fighting off a hostile takeover by a U.K. water utility. And The Southern Co., an Atlanta utility holding company, is bidding for South Western Electricity PLC, Bristol, England.
Because competition in the United States is bringing together both strong and weak companies, it is hard to predict who the winners and losers will be, Mr. Weiss said.
"We are staying away" until the shakedown is over, he said.
Electric utilities still dominate the $2.1 billion Duff & Phelps Utilities Inc. mutual fund. But Richard Spletzer, chief investment officer, said he has been boosting the fund's exposure to telephone companies and real estate investment trusts and unloading the stocks of electric utilities "because of the higher risks of the industry."
Those who plan to ride out the industry's tough times advocate two investment strategies: pick low-cost producers that are also well-managed and financially strong; and choose companies whose stocks have been unduly battered because of fears of deregulation.
In the first category, Federated's Mr. Wiles said are companies such as Duke Power Co., Southern Co. Services Inc., PacifiCorp. and UtiliCorp United Inc. Wheat First Butcher Singer's Mr. Hamlin likes DPL Inc., the parent company of Dayton Power & Light; FPL Group Inc., the parent of Florida Power & Light; TECO Energy Inc.; and Scana Corp., the holding company for South Carolina Electric and Gas.
In the second category, Mr. Wiles favors such companies as Public Service Enterprise Group Inc. and Texas Utilities Co. They "are being treated as losers" by the market, but can make it to the survivor category, he said. However, Mr. Wiles shuns ordinary companies "that are bit more stodgy and bondlike."
Meanwhile, Wellington's Mr. Ryan prefers to do just that.
He is staying away from the perceived winners because their stocks are pricey. Instread, he is investing in middle-of-the-road utilities "that will manage their way reasonably well through the transition period where their valuations do not reflect them as winners."
He has 40% of the fund in electric utilities.
He has put his money on General Public Utilities Corp., trading around 10 times expected 1995 earnings of $2.90 per share, and $2.95 per share in 1996. The stock is yielding of 6.5%, and he expects earnings to grow around 3% - "very plain vanilla," Mr. Ryan said.
He also likes DQE Inc. He said it has good management, is well-positioned geographically, yields 5% and has projected earnings growth of 4% to 5% a year.
Then there's Pacific Gas & Electric Co., whose stock took a beating last year when California regulators announced plans to open up sales of power by 1996. State regulators have since retreated from their aggressive timetable, Mr. Wiles said, but the stock is still in the dumps. The company is trading at 10.4 times projected 1995 consensus earnings of $2.85 cents (although Mr. Ryan is discounting earnings to $2.70 per share), and has a robust 6.7% dividend yield.
Meanwhile, Duff & Phelps' Mr. Spletzer said Baltimore Gas and Electric Co., IPALCO, Carolina Power & Light Co., GPU Service Corp., NIPSCO Industries Inc., FPL, TECO and Southern Co. represent a sampling of companies in his portfolio with higher potential earnings and dividend growth than the market but with relatively cheap valuations.
"These are fine-quality companies, they generate power cheaply, have good management and strategic plans," he said.