Monday, July 8, 2013

High Dividend Utility Stocks – Are they a trap for income investors?

Utility stocks have traditionally been seen as safe investments by retirees looking for high current income. The sector is well known for its rich dividend policies, as most companies in the group tend to distribute an above average portion of earnings out to shareholders in the form of dividends. As a result, most utility stocks end up paying above average yields to investors. It is not surprising then that many retired investors have preferred utility stocks for their high yields.

I own shares of two utility companies at the moment in my personal portfolio - Dominion Resources (D) and Con Edison (ED).

Dominion Resources, Inc. (D), together with its subsidiaries, engages in producing and transporting energy in the United States. This dividend achiever has raised distributions for 10 consecutive years. Over the past decade, distributions have been raised by 5%/year. The stock is trading at 16.80 times forward earnings and yields 4%.

Consolidated Edison, Inc. (ED), through its subsidiaries, engages in regulated electric, gas, and steam delivery businesses. This dividend champion has raised distributions for 39 consecutive years. Over the past decade, distributions have been raised by 0.90%/year. The stock is trading at 15.10 times forward earnings and yields 4.20%.  In 2012 I sold most of my stock in Con Edison and replaced it with ONEOK Partners (OKS). This remaining position in the stock accounts for 0.07% of my total portfolio size, because it is sitting in a legacy account, where the transactions costs and paperwork involved are prohibitively high in relation to the position size. As a result, I am better off simply sitting on it. Dominion accounts for 1.56% of total portfolio size.

The business model of a typical utility is pretty stable. Most publicly traded utilities are involved in the generation and/or transmission of electricity, natural gas or water. Utility companies are heavily regulated and have the monopoly to conduct their business over a certain geographic area. Governments have decided that competition for a service such as electricity would be too costly over a certain geographic area, and have thus granted the monopoly to the utility company. The corporation has to abide by the government regulations however, which limit how much prices can be increased and what target return on equity should be achieved. This creates a very stable business environment, which is characterized by consistent cash flows, and stable dividend payments. You would not see a utility company delivering double digit earnings increases over time, but you would also not see many utility companies going broke either.

Despite this stability, few utility companies have managed to have a long and meaningful records of dividend growth. I analyzed the dividend records of the companies comprising the Dow Jones Utilities average index, and noticed that most utility dividends do not tend to increase over time. It is evident that utility dividends tend to increase for a period of one or two decades, before the rise is interrupted followed by a steep cut in distributions. After the dividend cut, distributions start increasing once again, before reaching a high point, after which dividend growth stops or turns into dividend cuts again. This cyclical nature of utility dividends exposes investors to the ravages of inflation, since purchasing power of these distributions is eroding over time without any meaningful growth.


There are many reasons behind dividend cuts for utilities.  Some of them include nuclear disasters, failure to effectively deal with regulators, or failure to effectively pass on cost hikes to consumers.

Incidentally, because of the cyclical nature of dividend cuts and increases, utilities are one of the few sectors where it might make better sense to purchase after a dividend cut. For example, Con Edison suspended dividends in 1974, from the 11.25 cents/share paid every quarter. Later in 1974, the company initiated a quarterly dividend of 5 cents/share, which has been increased ever since. $1 invested in the company after the dividend elimination would have turned into over $350 over the next 39 years.

Most younger Americans do not remember the Three Miles Accident in 1979, which was a partial nuclear meltdown that occurred in one of the two United States Three Mile Island nuclear reactors in Dauphin County, Pennsylvania, on March 28, 1979. It was the worst accident in U.S. commercial nuclear power plant history. The project was operated by General Public Utilities (GPU), which cut dividends in 1979 and then suspended them in 1980. The dividend was not reinstated until 1986, but by 1992, the stock was up almost 9 times in value since the accident, and the dividend exceeded the amounts from before the accident. GPU is now part of FirstEnergy (FE).

That being said, utility companies could be good investments that can generate current income in retirement for retirees. However, always make sure you get the facts, prior to investing in utility companies. This involves reading annual reports, purchasing at attractive valuations and not over committing your portfolio allocation to this or any particular sector. At this moment however, I do not view utility companies as favorable investments as a group, because of their low current yields and low expected growth rates. If I had held utilities purchased at least several years ago at lower prices however, I would probably keep holding to these shares, although dividends would be either spent or allocated elsewhere.

Full Disclosure: Long OKS,ED, D.

Relevant Articles:

Why I am replacing ConEdison (ED) with ONEOK Partners
Utility dividends for current income
Dividend Investors – Do not forget about total returns
Dividend Champions - The Best List for Dividend Investors
Reinvest Dividends Selectively

9 comments:

  1. The Three Mile Island accident brought back some memories.I was at a presentation at the National Press Club in D.C. by Bob Torray the well known contrarian investor in 1979 and the audience hung on every word as he described his investment style. Many undoubtedly thought they could duplicate his success until he mentioned his most recent big purchase. You guessed it - GPU. The audience let out an audible gasp. He hit a homerun with it of course. Contrarian investing is not easy!

    ReplyDelete
  2. I've been reading all over your blog for the last few months. First off, thanks for sharing your journey and knowledge.

    Can you explain why it would be a poor idea to do the following: Buy a utility paying high dividends. When dividends get cut, sell your stake, and buy another utility that is paying high dividends.

    If I have $1 to invest and I get a 2.5% dividend yield on the shares I purchased with that dollar, would it matter if I have 1 share of $1 stock or 10 shares of $0.10 stock?

    Thanks,
    Spencer

    ReplyDelete
    Replies
    1. I agree, you can do as suggested. However, (1) depending on the reason for the cut, you can also loose some of your principle, (2) there
      are may be cost associated with the transaction, (3) you may not be the only person thinking about selling. Nevertheless, it's all about
      timing.

      Delete
    2. Lose, not loose.

      Delete
  3. DIY,

    I had never heard about Bob Torray. I would research his record. Thanks for mentioning this.

    Spencer,

    Thanks for reading. If I understood you correctly where you are coming from, the issue with your strategy is that after a company cuts dividends, there is a high likelihood that you would suffer losses in capital and income. Therefore, instead of owning a $1 stock paying 5 cents in dividends, you end up owning a 50 cent stock paying a 2 cent dividend after the cut. If you need 5 cents to live off, then you would have a 3 cent shortfall in income needed. Using the new capital base of 50 cents, you would need to find something that yields you 10% ( or 5 cents), which could or could not be possible, and might lead you to select another risky security which could cut distributions.

    You see, this could cause a vicious cycle.. That's why I try to avoid buying companies that I think have a higher chance to can cut dividends in the near future. Of course, no matter how careful I am, I am destined to pick a few losers over the next 30 -40 years ( along with the winners). Stay tuned, and keep reading this site - I will try not to disappoint you either way.

    ReplyDelete
  4. Tend to agree that utitilies are not a great buy in the current environment. The only energy utility I have in my 43-stock portolio is 200 shares of CMS Energy (CMS) that I bought in Aug. 2010 at $16.91. Today it's at $26.02 for a three-year gain of 53.87 percent (ex. divs).

    The dividend has been bumped up three times for a 21.4 percent increase. Annual payout per share is $1.02, so every quarter I get $51.

    CMS's share price is fairly steady. While utilities may not be barnburners the dividend is okay. To move into something with greater growth and still receive the $51 quarterly dividend on 200 shares, would require, assuming getting 100 shares @ $52.05 (today's value of 200 CMS) getting a stock yielding 4 percent.

    A difficult choice to make, no? Sometimes, the tortoise approach is the best.

    ReplyDelete
  5. Malcolm,

    Good comment. If you owned a stock like CMS with such a low basis, it might make sense to hold on to it, and use the dividend income to fund other investment opportunities, which are attractively priced today.

    Thanks for stopping by!


    Dividend Growth Investor

    ReplyDelete
  6. DGI: Yes, that's the point. Using the cash flow from dividends to buy shares in other companies. You might want to take a look at TAL Intl. I bought 100 shares in May 2011 @ $33.14. Today, it's @ $46.86 for a 41 percent increase (ex. divs.). My yield is 8.21 percent. The yield now is 5.8 percent.

    But look at the past 11 quarters of per-share dividend growth since I bought it: 50 cents/52/52/55/58/60/62/64/66/68/68.

    Last year the company increased its dividend every quarter, pushing it from 55 cents to 62 cents. Not many companies like that around!

    ReplyDelete
  7. There is a place for utilities in everyone's dividend portfolio. However like DGI always says, keep it spread out and don't over-commit to any one company.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts