Not Your Grandmother's Utilities
| "Ah, this is obviously some strange usage of the word 'safe' that I wasn't previously aware of." |
| -- Douglas Adams Arthur Dent in "The Hitchhikers Guide to the Galaxy" |
P UNTIL A FEW YEARS AGO, investors bought utility stocks for their hefty dividends. Water, gas, and electric utilities generated a lot of cash, but just weren't viewed as growth businesses. Most operated within a specific geographic region and were regulated by local authorities.
Everyone needed their products so they generated a steady revenue stream, but being heavily regulated and locked into their specific territories there was little growth opportunity. As a 
result, excess cash was returned to investors in the form of dividends. If you wanted income, utilities were a viable substitute for bond investments. Aside from grandmothers, there was little to interest most investors.
Deregulation changed all that. In the Nineties, many states moved to open their utilities markets to competition. By allowing companies to vie for the business, efficiency has increased and prices have come down. (Californians may beg to differ, but then they didn't really deregulate their utilities.)
As a result, utilities -- especially electric utilities -- are no longer tied to specific geographic regions. Companies such as Duke Energy or Southern Company's Mirant sell their power on both coasts.
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Chart 1: |
 Data Source: Baseline In 1991, utilities' payout ratio peaked as earnings bottomed. Ever since, payouts have been falling as earnings have been on the rise. This is usually characteristic of growth stocks. |
In addition, there's now a new breed of utilities, the independent power producers. Companies like Dynegy and Calpine serve no specific territory but instead sell their power to other utilities. AES has distribution networks in Latin America and South America as well as in the U.S.
Enter Growth
The opportunity to enter different, more profitable markets provides new growth opportunities. Utilities now have another use for their profits rather than dividends. As Chart 1 illustrates, after bottoming in 1991, the S&P 500 Utilities' profits have been rising while payout ratios have declined. "Growth utility" is no longer an oxymoron.Growth investors have discovered the "new" utilities. When they abandoned techs in March 2000, they bought utilities. For those that did, it was a good move as over the next 16 months, the S&P 500 Utilities rose 18% while Technologies fell 59%. Growth investors would never have been caught dead near your grandmother's utilities.
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Chart 2: |
 Data Source: Ibbotson Associates Although utilities started to look like growth stocks in the 1990s, they haven't traded like them. Correlations between utilities and traditional growth stocks have actually fallen. |
But if utilities are becoming growth stocks, are they now trading like other growth stocks? Evidently not as correlations have continued to fall when compared with other growth sectors such as Technology, Healthcare, and Financials. Chart 2 demonstrates this point by comparing correlations over three year periods starting in 1986 (the common start date for the sector data) and ending in 2000. Throughout the overall period, correlations have declined.
Modern Portfolio Opportunity
If utilities' earnings are growing and correlations with other growth stocks are falling, there's an opportunity here. According to Modern Portfolio Theory, risky assets with low correlations can be combined to create portfolios with lower risk and/or higher return than the individual assets. This should happen if we combine utility stocks with those of other growth sectors.|
Chart 3: |
 Data Source: Ibbotson Associates The S&P 500 Utilities and Technology sectors have relatively low correlations. Over the 15-year period 1986 - 2000, the optimal mix would have been 56% Tech, 44% Utilities. Even so, a 50/50 mix like an average investors might use still outperformed each sector and the S&P 500 itself. |
To test this, we created portfolios combining the S&P 500 Utilities sector with S&P 500 Technology sector. Technology was chosen because it had the lowest correlation over the 1986 - 2000 measurement period, 0.07. Initially we sought the most efficient mix with the same risk (standard deviation) as the S&P 500. According to Ibbotson optimization software, a 56%/44% Technology to Utility split would have been the most efficient, returning 840% over the measurement period.
That would have been the optimal portfolio, but no one would have really been that precise. To get a more realistic comparison, we also considered a 50%/50% blend, something an investor might actually try. Surprisingly, its cumulative return only dropped 4% to 836%. Over the same time period, the Technology and Utility sectors returned 758% and 673%, respectively, while the S&P 500 rose 757%. Results are shown on Chart 3.
Risk and Return
Obviously the cumulative numbers don't tell the whole story. While portfolios mixing stocks from the technology and utility sector would have outperformed over the entire period, there are specific times when it would have been better to be fully invested in technology stocks (late 90s) or all utility stocks (early 90s). But while this might yield better returns than even the blended portfolios, market timing the sectors introduces two problems.First, in order for it to work, you have to know when to switch between sectors. This is critical for as you can see from Chart 3, sector outperformance can occur quickly and dramatically. Just look at the tech run up from late 1998 to early 2000. Also notice how quickly all the gains were lost in only a few months of 2000. If you were late switching into or out of the sector, you missed most of the gains.
Which brings up the second problem: Concentrating a portfolio in one sector is only a little less risky than concentrating in one stock. Everyone knows the benefits of diversification when it comes to individual stocks. Holding just one or two stocks exaggerates the effect of any news or company-specific event impacting those issues. By diversifying with additional stocks in different businesses and areas of the market, you spread your risk and quite possibly enhance return.
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Chart 4: |
 Source: Ibbotson Associates When comparing return for the period 1986 - 2000 and risk (as measured by standard deviation), the 50/50 Tech/Utilities mix falls just short of the optimal return yet has the lowest risk of the lot. That's the benefit of combining different stocks with relatively low correlations. |
The same is true for stocks from different sectors. Chart 4 compares the cumulative returns and risk of the technology and utility sectors, the S&P 500, and the 50/50 and 56/44 mixes over the 1986 - 2000 measurement period. Risk is measured by standard deviation -- the average volatility about the series' mean return. The lower the standard deviation, the lower the volatility and lower the risk.
The Tech sector's return was almost identical to that of the S&P 500, yet its risk was much higher (29% vs. 18%). In other words, a diversified portfolio holding all S&P 500 sectors would have produced the same return as a pure tech portfolio, but with only a fraction of the risk. At least over this time period, diversification reduced risk without adversely affecting return.
Over the same measurement period, stocks of the Utility sector had slightly less risk than the S&P 500, yet significantly less return (673% vs. 757%). Here the lack of diversification hurt return without significantly improving risk.
The two blend portfolios are the most interesting. By combining stocks from the Technology and Utility sectors, they delivered returns exceeding the S&P and the sectors themselves, while maintaining the level of risk. This is a prime example of the benefits of diversification.
By combining stocks from these two sectors, growth investors can have their cake and eat it too. The low volatility of the utilities counteracts that of the techs while their low correlation implies that when one is lagging the other will be leading.
Grandma may not have pictured herself as a growth investor, but she probably knew the benefits of diversification.
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