It's a rule of thumb on Wall Street that when interest rates rise, utility stocks fall. That's because utilities, with their hefty dividend yields, tend to be treated like bonds. True to form, electric utility shares are down 3.5%, vs. 1.2% for the Standard & Poor's (MHP ) 500-stock index, since rate-hike fears began rattling the market in March. But investors who flee utilities today may be missing the bigger picture.
After reeling from fiascoes such as Enron, the industry seems to have stabilized. Power prices are rising again after collapsing in 2001. At the same time, utilities are getting back to basics, retiring debt and building plants that will generate fixed rates of return. Profits for the 37 electric and gas utilities in the S&P 500 should rise 2.6% this year, according to Reuters Research (RTRSY ). That will give them the cash to raise dividends, keep share prices up, and break their link with bonds. "There's not a lot of downside to owning utility stocks right now," says Morningstar Inc. utility analyst Venkatesh Vadlamani.
Companies that can count on friendly state regulators to grant regular rate increases are the safest. Green Bay's WPS Resources Corp. (WPS ), parent of Wisconsin Public Service Corp., has had two rate hikes in the past year and now pays a 4.82% yield. It plans to add to future earnings by investing $1 billion in transmission lines and power plants in coming years. "Good treatment by regulators, growth in customers, sufficient cash flow to make periodic dividend increases -- those are the things I look for," says Ronald J. Sorenson, executive vice-president of utilities specialists W.H. Reaves & Co.
With wholesale electricity prices rising, companies with extra power to sell are poised to clean up. Those using coal or nuclear power have a big advantage over competitors burning high-priced natural gas. Exhibit A: Exelon Corp. (EXC ) in Chicago, parent of Commonwealth Edison Co. After several purchases, it is the largest owner of nuclear plants in the U.S. Jefferies & Co. (JEF ) analyst Paul B. Fremont figures Exelon's earnings could climb 9% this year.
Of course, companies selling natural gas can benefit from higher prices, too. Consider Salt Lake City-based Questar Corp. (STR ), a natural-gas distributor that has ample reserves and a fast-growing production business in the Rocky Mountain and Southwestern states. Robb Parlanti, a senior portfolio manager at money-management firm Turner Investment Partners Inc. in Berwyn, Pa., thinks Questar could rise from its current price of $37 to $50 over two years if investors begin to value it more like an oil company and less like a utility.
Investors always like turnaround stories: Edison International, the big Rosemead (Calif.) utility, got walloped during the state's electricity crisis but is now burning bright. Having cut a favorable deal with regulators to pay off its crisis-related costs, the company is adding capacity that could set the stage for dividend increases, says David A. Kiefer, a co-manager of the $2.6 billion Jennison Utility fund.
Utility stocks may no longer be the worry-free widows-and-orphans investments they once were. But when interest rates are on the rise, it's good not to be treated like a bond.
By Christopher Palmeri in Los Angeles