Utility Funds Play Good Defense

Oct. 5, 2004 -- Utility funds, oftentimes ignored by adventurous investors seeking more aggressive returns, have recently outperformed the broader equity markets, which have been hampered by lackluster performance.

For the twelve-month period through September 24, the average utility fund soared 20.6%, while the Standard & Poor's 500-stock index gained 13.3%.

Longer term, however, utility returns have been less than exemplary. For the three-year period, the average utility portfolio was roughly flat, rising 0.7% annualized, versus 6.5% for the S&P 500. For the five-year period, utility funds rose 1.0%, versus a drop of 1.3% the Index.

Defensive, conservative investors like utility stocks because they provide stable, but modest, returns and above-average yields. Indeed, the sector has welcomed many investors seeking safe refuge from markets dampened by geopolitical tensions, record high crude oil prices, rising interest rates, and sluggish economic growth, among other concerns.

Chris Ingle, an analyst for the INVESCO Utilities Fund/A (IAUTX), points out that while sector rotation has propped up utilities, improving company fundamentals, healthier balance sheets, increasing free cash flow generation, a more favorable regulatory climate, and rising dividends have also drawn investor interest to utilities. [The Invesco fund will change its name to AIM Utilities Fund on October 15].

Two of the best-performing utility funds over the longer term -- Franklin Custodian Fds:Utilities Series/Adv (FRUAX) and Eaton Vance Utilities/A (EVTMX) -- have somewhat different investment approaches. Portfolio manager Judith Saryan had about 25.5% of the Eaton Vance fund's assets in telecommunication services as of June 30, including such names as Verizon Communications (VZ) and SBC Communications (SBC). About 55.9% of her assets were in utilities. John Kohli, the manager of Franklin Utilities, is more purely concentrated in utilities, with 76% of his assets in electric utilities, 16.2% in gas distribution and 3.5% in water companies as of August 3. His top holdings include FirstEnergy Corp (FE), Entergy Corp (ETR), Dominion Resources (D) and FPL Group (FPL). Both portfolios are ranked 5 Stars by Standard & Poor's.

Despite this recent outperformance, utility stocks are facing some headwinds, namely the Federal Reserve's commitment to tightening credit. "Higher interest costs do have a negative impact on profitability," Ingle stated. "Moreover, higher interest rates tend to make high dividend-paying stocks, like utilities, less attractive relative to bonds. Broadly speaking, increasing rates tend to drive utility stock prices down.

Indeed, utility stocks have fallen an average 10% six months after the Federal Reserve began multi-rate tightening programs since 1970, according to Sam Stovall, Standard & Poor's Chief Investment Strategist. This research also indicates that utility issues climbed an average 6% six months prior to the start of these rate hikes.

Ingle is responding to the rising rate environment by keeping core holdings in high dividend-paying utilities, while also uncovering certain lower-yielding companies, which are undergoing successful turnarounds. He cited TXU Corp. (TXU) as an attractive utility restructuring play. "New management at TXU is executing a successful turnaround," he noted. "TXU has been our best performer this year with the stock price doubling since the beginning of 2004."

Although record high oil prices are of grave concern to most stock pickers, they do not significantly impact utility stocks. "Electricity generators that use oil price-linked fuel sources will experience higher costs," Ingle explained. "However, oil is not a large component of the fuel mix in most regions. Regulated utilities typically pass through fuel cost changes to their ratepayers, albeit with a regulatory time lag."

Looking ahead, Ingle maintains a cautiously optimistic stance. "The utility sector is returning to its historical risk-return profile," he said. "Many of the troubled companies of 2001-2002 have made significant restructuring progress since then. My outlook for 2005 is for moderate earnings growth with sustainable dividend increases."

Five Best Utility Funds For One-Year Period (thru 9/24/04)

Fund

Return (%)

S&P Star Ranking

Expense Ratio (%)

Jennison Utility Fund/Z (PRUZX)

30.1

3

0.91

Evergreen Utility and Telecom/I (EVUYX)

27.8

3

1.30

Gartmore Global Utilities/IS (GUISX)

26.3

N.A.

1.20

Strong Advisor Utilities & Energy Fund/A (SUEAX)

25.4

N.A.

1.90

MFS Utilities Fund/I (MMUIX)

25.3

3

0.94

Five Best Utility Funds For Three-Year Period (thru 9/24/04)

Fund

Annualized Return (%)

S&P Star Ranking

Expense Ratio (%)

Eaton Vance Utilities/A (EVTMX)

7.9

5

1.15

Franklin Custodian Fds:Utilities Series/Adv (FRUAX)

6.6

5

0.69

Gabelli Utilities/AAA (GABUX)

5.9

5

2.00

MFS Utilities Fund/I (MMUIX)

5.4

3

0.94

ICON Telecommunications & Utilities (ICTUX)

4.4

3

1.41

Five Best Utility Funds For Five-Year Period (thru 9/24/04)

Fund

Annualized Return (%)

S&P Star Ranking

Expense Ratio (%)

Franklin Custodian Fds:Utilities Series/Adv (FRUAX)

8.0

5

0.69

Gabelli Utilities/AAA (GABUX)

7.3

5

2.00

FBR American Gas Index Fund (GASFX) 5.6%

5.6

3

0.85

Eaton Vance Utilities/A (EVTMX)

5.4

5

1.15

Jennison Utility Fund/Z (PRUZX)

5.2

3

0.91

Standard & Poor's. Total returns include reinvested dividends. Data as of 9/24/04.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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