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Frontlines

Will a back-to-basics strategy meet investor expectations?
Fortnightly Magazine - October 2004

themselves?"

Furthermore, he says that instead of increasing dividends, corporations are trying to preserve financial flexibility by using the cash to buy back shares in the face of economic uncertainty and are concerned that the dividend tax reductions of 2003 could be repealed. As evidence, non-financial corporate net equity issuance declined to minus $160 billion at an annual rate in the second quarter 2004, or nearly three times the decline in 2003. Certainly, stock buybacks have been the order of the day in the utilities industry. Berner says, "As CFOs consider future growth alternatives, acquisitions and dividends will compete for that cash. And many will be forced to step up buybacks to avoid dilution from options exercise; already my colleague and equity strategist Henry McVey notes that for the top 25 companies, 40% of the buybacks merely offset dilution. Which CFOs are good stewards of that cash could prove pivotal in future investment returns." And good stewardship in the utilities industry means upping the dividend as investors rediscover utilities in a low-growth environment.

A Lower-Return Universe

Growth expectations for corporate America and the U.S. economy overall are not that strong. Perhaps that is why utilities are faring better with investors and why utility finance chiefs are being cautious about their growth plans. In an interview with CBS MarketWatch, Don Cassidy, a Lipper senior research analyst, put it succinctly. "In the environment we're now in … investors would rather have $1 of dividend in hand than the promise of $2.50 of earnings going to $3. Utilities should become increasingly popular."

"The sector looks incrementally attractive in several aspects of our work," Richard Bernstein, Merrill Lynch's chief U.S. strategist, wrote about utilities in a research note a few weeks ago. Bernstein said investors should expect annualized U.S. stock returns of between 5 percent and 7 percent over the long term. Against that backdrop, even a 3-percent yield is a nice head start, he says. And economic forecasts seem to support an ongoing low-growth environment.

Steve Roach, managing director and the chief economist at Morgan Stanley, writing in September, believes "that the economic recovery, by most conventional measures, has been amazingly lousy."

"Annualized growth in real GDP has averaged 3.4% over the first 10 quarters of this upturn, far below the 5% norm of the previous six business cycles," Roach says. "Non-farm payroll employment is up only 0.1%, on average, over the past 10 quarters-hugely deficient when compared with the 2.7% record of the past six recoveries. Real wage and salary disbursements-the essence of the economy's organic, or internal, income-generating capacity-is up at only a 0.8% average annual rate over the past ten quarters versus the 3.9% norm of the previous six upturns. The federal government budget is out of control, having swung from surplus to deficit by six percentage points of GDP from 2000 to 2003. This was key in pushing the net national saving rate down to its all time low of 0.4% of GNP in early 2003. Lacking in domestic savings, the U.S. has had to import foreign savings in order to