The spark has gone out of electric utilities stocks in the past few months. During the week ending Feb. 17, the S&P 1500 Electric Utilities subindustry index's trailing 52-week relative strength ranking (RSR) dropped to 3 (middle 40%) from 4 (top 30%). Had this group been on the High Momentum List (having reached an RSR of 5 -- top 10% -- and retaining a ranking of 5 or 4), it would have been removed from the list because of the current longer-term price erosion.
Of course, investors in these issues are probably not overly disappointed, in our opinion, since this group rose 11.7% in 2005, vs. a 3.8% advance for the S&P 1500. And the group has gained 2.4% year-to-date through Feb. 17, vs. the broader market's gain of 3.5%. But turning paper profits into actual ones is a tenet of successful investing.
As can be seen in the accompanying chart, the rolling 12-month relative price performance for this group has exceeded that of the overall market, but is continuing the decline from its mid-2005 highs. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the previous year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 14-year mean relative strength.
BUYBACKS ON THE HORIZON?
S&P equity analyst Justin McCann has a neutral fundamental outlook for electric utilities. He thinks the outperformance in 2005 reflected a shift into stocks perceived as defensive, but he believes the sector is now fairly valued. He believes the repeal of the Public Utility Holding Company Act could further stimulate the consolidation taking place within the industry, as well as open it up to acquisitions by nonutility investors, including foreign companies. The stocks of utilities with secure dividends and high yields have benefited from the tax cut on dividends, and with increased free cash flow seen, he expects more companies to increase their dividends.
McCann expects favorable earnings-per-share comparisons for 2006, aided by many fewer dilutive issuances of new equity, an increased level of share buybacks, and the divestiture of underperforming noncore businesses. These positives should help offset the high pension-related costs that utilities face, which have restricted earnings growth for many companies. The "back to basics" trend that has been taking place has, in his opinion, helped enhance the investment appeal of some companies. While the long-term trend of industry consolidation has slowed, he thinks the planned mergers could revive it.
Given the lingering impact of the California power crisis and the Enron scandal, the deregulation of the industry has slowed to a standstill. He believes it will eventually resume, but in a more judicious manner.
While power prices have rebounded significantly from their sharp decline in 2001 and 2002, the extremely high prices of 2000 led many states to adopt a go-slow approach to the separation of generation from transmission and distribution units. In states that required this separation, the utilities were generally allowed to recover their "stranded costs" (costs related to power-generating plants that could not be recovered in a competitive market, or to long-term purchased-power contracts). McCann expects that the successful utilities will be those that pay down debt and provide stable earnings and dividend growth.
So there you have it. From both a fundamental and momentum standpoint, S&P believes the investment outlook for the S&P Electrical Utilities group is neutral over the coming 12 months.
Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), their proxies (the highest STARS-ranked companies in the subindustry index-tie goes to the largest market value) as of Feb. 17, 2006.