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Tickers in this Article: AES, CEG, CMS, DUK, ED, EXC, PGN, SO
So far, 2012 has not been a banner year for US utilities in general, but there are some specific companies that are still worth picking up now, writes Roger Conrad of Investing Daily.

In the income-investing universe, the Alerian MLP Index set at a new all-time high last week. So did the S&P/Toronto Stock Exchange Income Trust Index—believe it or not, it’s once again trading at a higher level than it did before Canadian Finance Minister Jim Flaherty’s infamous Halloween 2006 announcement of new taxes.

In stark contrast, however, the Dow Jones Utilities Average (DJUA) is actually down in 2012, by about 2.6%, and several components of the group have fared even worse. Exelon Corp (EXC) is off by more than 9%. Even group safeties Consolidated Edison (ED) and Southern Company (SO) are off 6.5% and 4%, respectively. Were it not for the robust performance of AES Corp (AES)—which is up 15%—the DJUA would be a lot lower.

At least part of this underperformance can be explained by seasonal factors. Utility stocks are still among the most heavily held groups by individual investors, and most of these folks don’t think of them as trading vehicles. There is, however, a distinct seasonality to performance.

Thirty-six times since 1969, the DJUA has rallied in the fourth quarter of the year, i.e. from October 1 through December 31. The only exceptions were years of major market dislocation, such as 2008 and 2001 and 2002, when the sector was in its worst bear market ever following the Enron meltdown.

The flipside is that utility stocks have tended to unwind those gains in the first quarter of the year, meaning they’ve generally underperformed other stocks.

One plausible explanation is that coming into the end of the year, large institutions rebalance their portfolios to lock in gains by loading up on reliable stocks paying big dividends.

The 2008 meltdown showcased once again the recession-proof nature of essential-service revenue, making utilities the logical choice for such buying. Conversely, institutions’ desire to make more aggressive bets to start the year leads to selling of the safeties and making bets on stocks with the perceived potential for bigger returns.

I’ve taken advantage of these trends the past few years by recommending leveraged exchange traded funds from the ProShares family. And I’ve advised readers to look to buying individual stocks when prices are lower, rather than when they’re rising in the fourth quarter.

Some readers have asked me if I think there’s something bigger going on that will keep the sector in the doldrums the rest of 2012 and possibly beyond. And several attendees I met at the World MoneyShow Orlando last weekend wondered if there was any merit to holding an underperforming group when there were higher yields elsewhere.

These are questions that always come up when an individual stock or sector lags the market. And with the memory of 2008 so fresh, they’re understandably coming up a lot more often than usual. Most investors have little tolerance for pain at this point. Any dip in a stock’s price—no matter how insignificant percentage-wise—is enough to stir their consternation.

I put today’s worries into one of two categories: factors that can definitely affect returns and are therefore worth taking into account with your investment decisions, and factors that simply reflect others’ neuroses and the need for the financial media to keep investors’ attention.

Front and center in category two is inflation. Yes, the price of some favored goods and services is still rising. But as an economic force, it’s deflation that’s still by far the bigger worry. In the US, high unemployment and the lagging housing market fuel deflation. In Europe, it’s an unfolding recession, as governments tighten their belts to maintain access to credit. In the developing world, ironically, it’s government efforts to slow growth.

For utilities, the biggest worry in such an environment is ability to access credit. The really good news is since late 2009, corporate borrowing rates in the US have been near all-time lows. Even financially weaker utes have been able to refinance debt at very low rates while pushing out maturities years into the future.

Even if credit conditions do tighten, these companies will be able to delay debt offerings until the market improves. We’ve seen this happen several times since the economic/market recovery began in early 2009. And with financial management so conservative, companies become ever more resistant each time rates drop. Utilities are also locking in financing for long-term capital spending programs.

I fully agree that the market has much more influence over corporate borrowing rates than the US Federal Reserve’s zero-rate policy, or whatever S&P and others do to Uncle Sam’s credit rating. But the action on the ground is still that utility companies are borrowing at their lowest interest rates ever, and that’s very bullish.

The US economy also doesn’t appear to be nearly the worry it was for utilities just a few months ago. True, overall fourth-quarter sales are down for most power and gas companies. The reason, however, is mild winter weather, which more often than not becomes the next season’s heat wave. Meanwhile, even Michigan-based CMS Energy (CMS) has reported its industrial sales are back at pre-recession levels.

Industrial sales, not overall sales, are the best possible indicator that local economies are improving and boosting utilities’ underlying sales. They also mean regulators are under less pressure to hold back on rate increases to pay for needed investment. The latter does remain a problem for companies operating in some states, where officials are trying to ride utility-bashing in an election year.

But better economics are a major plus for preserving the regulator-utility cooperation that’s prevailed in most of the country since the Enron meltdown. And in the long run this is a huge plus for companies’ health and ability to grow dividends.

So what should we be worried about? Federal Energy Regulatory Commission (FERC) Chairman John Wellinghoff this week told reporters the agency wouldn’t update its policies regarding utility merger approvals as the US Dept of Justice and Federal Trade Commission (FTC) did in 2010.

This may or may not cause further delay for Duke Energy’s (DUK) merger with Progress Energy (PGN) or Exelon’s union with Constellation Energy Group (CEG). But it does increase the risk of holding Progress and Constellation stock, both of which would drop if these deals did come apart. The good news is both deals appear to have wrapped up state regulators’ approval, which has traditionally been the biggest hurdle to utility mergers.

The sharp drop in natural gas prices has been a major boon to many power utilities. They’ve been able to accelerate their switch from older coal-fired plants to new gas-fired plants with regulators’ support, thus simultaneously boosting rate base, cutting exposure to new air-quality rules from the Environmental Protection Agency (EPA) and reducing fuel costs, since coal is still quite high priced globally.

On the other hand, falling gas prices have triggered a corresponding drop in wholesale power prices in many states. This doesn’t matter a whit to Southern Company and other utilities that are still almost wholly regulated, as they sell into monopoly markets. Nor does it matter to power producers that have locked in long-term contracts for their output.

It does matter, however, to companies selling into wholesale markets whose contracts are expiring and hedges are coming off. And that’s a key fact for utility investors to find out about the stocks they own.

Finally, many investors are concerned about the potential impact on utility stocks of the expiration of the top 15% tax rate on dividends. This rate will expire in 2013 unless Congress passes legislation to extend it.

This is an unknowable at this time. For one thing, what happens will depend heavily on which political party is more powerful in Washington after November’s elections.

Republican candidate Mitt Romney and his party’s Congressional leadership are fully in favor of extending the rate, if not tackling the question of double taxation of dividends once and for all. Democrats, led by President Obama, have staked out the position that the lower rate should expire for those making over $250,000 a year.

No matter what happens in November, the parties are going to have to compromise on the issue. And the result may or may not preserve the current dividend tax rate for upper-income earners.

However, it is indisputable that dividend-paying stocks—utilities included—moved little, if at all, when the preferential rate was first announced. This argues strongly against a negative reaction in these stocks if a higher rate is enacted.

True, utility dividend yields are generally lower today than they were back in 2003. But that was in the dark days following the Enron implosion, when some two-dozen companies were on the brink of bankruptcy. The real shocker would be if yields today weren’t well below 2003 levels to reflect the sharp drop in operating risk.

Given many investors’ continuing state of fear, it’s entirely possible there would be some downward reaction in utility stocks should it become clear that dividend tax rates were going higher. Master limited partnerships’ unit prices have certainly been knocked around periodically by wholly unsubstantiated rumors about possible taxation changes.

It’s possible to imagine almost anything being taxed at a higher rate under worst-case assumptions. Whatever happens, however, you only pay a tax on profit—and maximizing that profit should always be every investor’s most important objective.

I don’t like paying taxes any more than anyone else. But avoiding a great stock just because you’re worried dividends and capital gains might be taxed at a higher rate at some point in the future is never going to maximize your profits. And buying something just because it’s tax-advantaged has more than once resulted in a total wipeout for the unwary.

Even Canadian trust averages have now fully recovered from the 2006 taxation announcement—and that was despite going through the worst credit crunch/market meltdown/recession in 80 years along the way. The same will be true of any stock backed by a strong underlying business, should taxes go up next year.

The message couldn’t be clearer: Always buy the business first, the tax dodge second (if at all).

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