Bill Gross's Utility Play

Guru Screen
Utilities Good Enough For Gurus And Bill GrossJohn Reese, Validea.com, 12.21.09, 06:50 PM EST
Utility stocks that sport fat yields or specialize in natural gas score well with models based on the world's best investors.

The historically low, near-zero interest rates that the Federal Reserve has kept in effect for the past year or so have been a boon for companies and corporate profits as we emerge from the credit crisis of 2008. Those low rates have a dark side, of course: They've made money market accounts useless for those looking to growth their cash and they've also made it tough to find nice yields among investment grade corporate bonds.
This low-rate climate is something PIMCO's Bill Gross discusses in his most recent investment outlook, a piece entitled, "Anything but .01%," a reference to the yield he says he's getting on his own money-market account.

The minuscule returns on cash and weak returns on many bonds have driven Gross to look at equities, and in particular to one specific sector. "In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt," he writes, "and many utilities provide just that opportunity. Utilities and even quasi-utility telecommunication companies now yield between 5% and 6%, whereas their 10- and 30-year bonds yield less and at a higher tax rate to you the investor."
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Gross' comments got me thinking about utilities, and the sector then caught my eye again last week for another reason, whenExxon Mobil ( XOM - news - people ) snatched up natural gas specialist XTO Energy ( XTO - news - people ). Exxon's CEO said natural gas is expected to be the fastest-growing major energy source, and the move led to speculation that other big oil players could follow with natural gas acquisitions of their own.
With all of this in mind, I decided to see which utilities get high marks from my "Guru Strategy" computer models, each of which is based on the approach of a different investing great. What I found was that that many of the highest yielders don't have the fundamentals needed to make the grade, making them what you might call "yield traps" (i.e., their businesses may not have the strength to sustain their high dividend payouts or their stock prices over the long haul).
Some utilities did score rather well with the strategies, particularly the approach I base on the writings of the great Peter Lynch. Here's a look at some of the favorites, including some that have the strong yields that Gross might like, as well as some that would stand to benefit from increased use of natural gas.
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RWE AG (RWEOY.PK): This Essen, Germany-based holding company manages RWE Group, the largest power producer in Germany and the second-largest in the U.K. It is involved in the generation, transmission, sale, and trading of electricity and gas, as well as the water business. The firm has 20 million electricity customers and 10 million gas customers, and it has plans to significantly reduce its current coal operations and almost double its gas operations from 2007 levels by 2020. The $47.2 billion market cap company is currently rewarding shareholders with a stellar 6.1% dividend yield.
RWE gets approval from the Guru Strategy I base on the writings of Lynch, one of the most successful mutual fund managers in history. Its 19.9% earnings per share growth rate (I use an average of three-, four-, and five-year EPS figures) and high sales ($68.3 billion over the past year) make it a "stalwart" according to the Lynch approach -- the kind of large, steady firm that Lynch found offered protection during downturns or recessions.
To find growth stocks selling on the cheap, Lynch famously used the P/E/Growth ratio, adjusting the "growth" portion of the equation to include yield for stalwarts, since they often pay solid dividends; yield-adjusted P/E/Gs below 1.0 are acceptable to my Lynch-based model, with those below 0.5 the best case. When we divide RWE's 11.3 P/E by the sum of its growth rate (19.9%) and yield (6.1%), we get a yield-adjusted P/E/G of 0.43 -- a sign that it's a bargain.
Lynch also liked conservatively financed companies, and RWE passes one of my Lynch model's balance sheet bonus tests, the net cash/price ratio. Lynch defines net cash as cash and marketable securities minus long-term debt, and a high net cash/price ratio (above 30%) dramatically cuts down on the risk of a security. At 45.8%, RWE easily makes the grade.
FirstEnergy Corp. ( FE - news - people ): This Akron, Ohio-based utility is the parent of seven electric utilities that form the U.S.'s fifth-largest investor-owned electric system. The $14 billion market cap firm serves 4.5 million customers throughout Ohio, Pennsylvania and New Jersey. Its stock is currently yielding about 4%.
FirstEnergy is another "stalwart" (18.2% long-term EPS growth rate and $16.5 billion in annual sales) that gets approval from my Lynch-based model. Its yield-adjusted P/E/G ratio is 0.51, falling just outside the strategy's best-case category, a sign that it's a bargain. FirstEnergy's debt/equity ratio (180%) is higher than 80% upper limit my Lynch-based approach uses for most firms, but because utilities generally carry higher debt loads than companies in other industries, the model doesn't see that as a problem.
DPL Inc. ( DPL - news - people ): Since I wrote about it back in early July, DPL--the parent of The Dayton Power and Light Company -- has gained almost 20% while paying a strong dividend yield. Dayton Power and Light supplies power to about 500,000 customers in West Central Ohio, generating a total capacity of 3,700 megawatts of electricity at 10 power plants. The stock, with a $3.4 billion market cap, is currently yielding a bit over 4%.
DPL remains a favorite of my Lynch-based approach, as it was back in July. While utilities usually produce slow or moderate growth, DPL's 22.6% long-term EPS growth rate makes it a "fast-grower" according to my Lynch model--Lynch's favorite type of investment. For fast-growers Lynch also used the P/E/G ratio, though he didn't adjust for yield since they typically don't pay the hefty dividends that stalwarts or slower-growing firms do. But even putting its solid 4% yield aside, DPL still has a 0.57 P/E/G, easily passing the Lynch-based model's most crucial test.
This Houston-based natural gas utility has about 20,000 miles worth of pipeline in the U.S., and serves more than half a million natural gas end-users in Missouri and Massachusetts. It has a market cap of about $2.7 billion.
Unlike the utilities I've mentioned so far, Southern Union isn't a big yielder--its 2.7% yield is decent, but slightly below the market average. But the firm is the lone U.S. utility in my database that gets approval from two of my Guru Strategies, earning high marks from both my Lynch-based model and my James O'Shaughnessy-based approach.
The Lynch model considers Southern Union a "fast-grower" because of its 26.4% EPS growth rate (based on the average of the three- and five-year figures). That growth rate and the stock's 11.4 P/E ratio make for a stellar 0.43 P/E/G ratio, indicating that the fast-grower is a bargain at its current price.
My O'Shaughnessy-based growth model, meanwhile, isn't as concerned with magnitude of growth as it is persistence. It targets firms that have upped EPS in each year of the last five-year period, and Southern has done just that. The O'Shaughnessy model also uses a critical pair of variables: the price/sales ratio, and relative strength. O'Shaughnessy found that stocks with high RS scores and low P/S ratios were being embraced by the market, but hadn't yet become overpriced. With a 1.19 P/S ratio and 73 RS, Southern looks good on both counts.
Entergy Corporation ( ETR - news - people ): Entergy owns and operates power plants with approximately 30,000 megawatts of electric generating capacity, and delivers electricity to 2.7 million utility customers in Arkansas, Louisiana, Mississippi and Texas. It also supplies natural gas to close to 200,000 customers in Louisiana, and is the second-largest nuclear generator in the United States.
With a 12.1% long-term growth rate and annual sales of more than $11 billion, Entergy is another stalwart that my Lynch-based model likes. The firm is currently yielding about 3.6%, which is part of why it has a solid yield-adjusted P/E/G of 0.94. Entergy, which has upped EPS in six straight years, also has a reasonable amount of debt for a utility, with a debt/equity ratio of 131%.
John P. Reese is founder and CEO of Validea.com and Validea Capital Management, and co-author of the new investing bookThe Guru Investor: How to Beat the Market Using History's Best Investment Strategies (John Wiley & Sons). He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best. Click here for more of Reese's insights and analysis, and to subscribe to the Validea Hot List.At the time of publication, John Reese was long SUG and XOM.