INSIGHTS

On November 06, 2012

Conservative Investors Continue to Seek Income with Utilities

Performance

Utility stocks, as measured by the Philadelphia Utility Index, rose 0.9% in the month of September versus a 2.6% increase for the Dow Jones Industrial Average. The relative underperformance came as long-term interest rates, as measured by the 30-year government bond yield, rose to 2.81% from 2.74%. A third round of economic easing has moved investor attention away from defensive equity and bond investments even as concerns of economic conditions in Europe and China continue to weigh on investor’s minds. In addition, we believe the chance of an Obama re-election has investors wondering what the impact of an increase in dividend tax rates would have upon utility stocks. For the record, we estimate that an increase in the dividend tax rate from 15% to 39% would result in a 10% decline in the price investors would be willing to pay for utility stocks. We believe investors believe that there is at least a 50% chance of such a dividend increase, meaning that the ultimate impact on utility stocks would be less than 5%. Furthermore, we believe there is a strong chance that the dividend tax rate cuts will be extended or raised at a rate that leaves them below the income rate.

Valuation

Utility stocks continue to trade at levels that are high relative to historical rates but attractive to other conservative income investments. The median price per earnings (P/E) for the group is 15.4 times forwards earnings, 8.1 times cash flow and 170% of book value. Earnings estimates dipped slightly for many utilities as the excitement surrounding warm weather in June and July began to subside. That said, we continue to believe the potential for favorable earnings results for the September quarter could lift the stocks as results are released over the next several weeks. Looking forward, we are beginning to see signs that cold weather this winter is lifting energy commodity prices. Near-term natural gas prices have risen from $2.95 per thousand cubic feet (mcf) to $3.50 per mcf in the month of September. This, in turn, is raising power prices, which has a favorable impact on merchant-power producers that fuel their plants with nuclear or coal energy. Ironically, utilities are not expanding merchant operations, but looking to sell assets. Dominion Resources (D) announced plans to dispose of three merchant power plants and some analysts have speculated that Edison International (EIX) may exit the merchant power industry.

We continue to believe that utility stocks can provide an attractive return for conservative investors seeking income with the potential for capital appreciation. Although valuation multiples are near historically high trading levels, the same can be said for other conservative, income investments. With a median dividend yield of 3.7% as of September 28, 2012 and estimated earnings and dividend growth of 3-5% we estimate that typically utility stock has the potential to provide investors with a total return of 7-9%. Such a return would represent a significant premium over the 2.8% yield provided by 30-year government bonds. Enough premium, in our opinion, to adequately compensate investors for the added risks involved in investing in utility stocks.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com


The information contained herein is obtained from Confluence Investment Management LLC and believed to be reliable. The information is not warranted as to completeness and accuracy and is subject to change without notice. The foregoing has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security.


Advisors Asset Management, Inc. (AAM) and Confluence Investment Management LLC are not affiliated and the views expressed in this commentary are not necessarily that of AAM.
Confluence Investment Management LLC is the Portfolio Consultant to the Confluence Utilities Portfolio. The Portfolio Consultant is not an affiliate of Advisors Asset Management, Inc. (AAM), the sponsor of this trust.