Investing in Utility Stocks the Right Way by Chad Shoop, The Sovereign Investor.
Over the weekend I read through Warren Buffett’s Annual Letter to shareholders, an item every investor should read. While it was extremely insightful, there was a bit in it that pertained to the topic I wanted to share with you today.
Warren Buffett has zeroed in on a little niche in the market that he believes has “recession-proof earnings.”
I like to consider it a stock market guarantee…
Unfortunately, there is no such thing as a true guarantee in the stock market. But there are a few little-known and widely overlooked stocks that exist today that are the next best thing…if not guaranteed, they are at least recession-proof stocks.
I would love to say that this group is an entire sector or even specific market, but the truth is there are only a select few stocks that present this opportunity today.
Utility stocks used to fill this small niche — once known as safe, stable income-generating stocks.
But that definition has morphed today.
Now utility stocks, otherwise known as power generation companies, can have volatile earnings and be anything but stable and safe.
That’s because the market has been deregulating over the past decade or so. It’s this unregulated utility market that almost all utility stocks have some exposure to, and there are even some that are completely composed of deregulated assets.
Since the unregulated power generation commands market prices, earnings and revenues tend to swing violently.
That’s not what I’d consider the next best thing to a guarantee.
Luckily, there are a few stocks that still operate in the regulated market, and I found one that is practically 100% regulated — Wisconsin Energy.
A regulated power market essentially means that a utility company’s costs are covered. It’s known as a “cost plus” model. Wisconsin Energy can adjust rates to cover its cost, plus an additional amount to generate a reasonable return on its assets.
This isn’t quite an assured profit because management can ruin a company numerous ways, but this is the next best thing.
As the Oracle of Omaha himself proclaims in his annual letter, utilities offer “recession-resistant earnings.” That’s because no matter what economic situation we are in — depression, recession or boom times — we all need power. Barring a management-led mishap, regulated power companies are assured to make a profit.
The regulatory component here is extremely important. The power market is forever changing. With solar, fuel cell and other new technologies coming online, there will have to be some adjustments in the power markets. But I don’t think it will ever fully abate from a regulated market.
The ability to generate additional power on demand to cool your house, refrigerate food, cook family meals, or even just having lighting in your home is not something we want to be on intermittent power.
There will ultimately be some consolidation in the industry through takeovers and mergers; maybe Wisconsin Energy is one of them. It was this time last year that Warren Buffett indicated he was looking to add additional utility assets, and Wisconsin Energy fit his requirements — 13% return on equity, excellent management team and practically 100% regulated power.
But I wouldn’t recommend Wisconsin Energy just on a possible acquisition though; there are plenty of reasons to like the company as is.
Shrinking Shares and Rising Dividends
With the stable and consistent cash flows Wisconsin Energy generates from its regulated business, the company projects to grow earnings per share between 5% and 7% and utilize a dividend payout ratio of 65% to 70% of earnings.
As you can see in the chart below, the company also has increased its dividends and reduced its shares outstanding over the past decade.
Cutting the amount of shares outstanding boosts the company’s bottom line, spreading income across fewer shares. This means increasing dividends, which puts more cash in your pocket.
These are two of the best uses of cash a company can choose. About the only other options are to invest in other companies — and Wisconsin Energy does that as well.
In November, it completed the acquisition of Integrys, a utility operator with $5.6 billion in revenues, to create a more diverse Midwest electric and natural gas power company.
All told, Wisconsin Energy is committed to bolstering shareholder wealth while growing its business. Picking up shares of Wisconsin Energy today is a chance to claim a growing 3.3% dividend yield and capture future profits. In a market where consistent, high-yield income is hard to locate, Wisconsin Energy presents an excellent opportunity to add steady income and growth to your portfolio.
Editor, Pure Income