Do electric utilities understand how to earn profits for shareholders in a competitive market?
Here's one way to look at the problem. Gather a group of financial experts and ask this...
Utility stocks have outperformed the broader market. Can the industry deliver a show-stopping second act?
The utility sector has been one of the best performing sectors in the equity capital markets for more than two years. A low interest-rate environment and investor focus on dividends has helped lift most utility stocks during the last several years. In many respects, this has been a case of the rising tide lifting all ships. But, as another cliche goes, it's only when the tide goes out that you see who is swimming naked.
Lost in the noise surrounding the recent passage of the Energy Policy Act of 2005 and concomitant repeal of the Public Utility Holding Company Act (PUHCA) are signals in the market that may indicate a change in how investors are likely to view the sector going forward. The recent strong performance of growth-oriented utilities in the secondary market, the success of ITC Holdings in the new-issue market, and the preference for companies with proactive shareholder-focused initiatives may each hold clues to investor preferences in the future.
The outperformance of the utility sector relative to the overall market that began in June 2004 owes as much to the fundamentals of the capital markets as it does to those of the industry. For example, the median year-over-year earnings growth that the market was expecting in June 2004 for the utility industry was nearly 6 percent-notable for the sector historically, but not as impressive when one considers that the market was expecting 18 percent EPS growth from the S&P 500. Furthermore, many investors were expecting a rising interest-rate environment that would be a difficult backdrop for yield stocks like utilities.
Equity capital markets issues, more than anything else, have had the most influence on the utility sector's outperformance. Beginning in 2004, the equity markets entered a period of remarkably low levels of volatility. In fact, as can be seen in Figure 1, the equity markets entered a period of low volatility not seen since the early 1990s. In an environment of low equity volatility, investors have a difficult time trading stocks to create incremental risk-adjusted return performance in their portfolios.
However, if an investor can borrow cheaply and fixed-income volatilities are low as well, then that investor may feel safe in borrowing with inexpensive capital to purchase high dividend-paying stocks.
As Figure 2 shows, most yield-oriented sectors share a similar trading dynamic, including real-estate investment trusts, master limited partnerships, and utilities. The stock prices of these seemingly unrelated sectors show a high positive correlation to one another (80 to 90 percent) during the June 2004 to June 2005 time period. As long as an investor's cost of borrowing remains low and the risk of being wrong ( i.e., low volatilities) is muted, investors, who are able to borrow and invest the proceeds in high-yielding securities, are incented to do so to enhance returns.