Unloved utilities generate electrifying returns

Once dismissed as stocks for widows and orphans, utility shares are achieving newfound respectability on Wall Street. Their high-voltage performance over the past year has drawn attention to funds that specialize in companies that produce electricity, distribute natural gas, and develop oil and gas properties.

Utility sector funds, belying their reputation as highly interest-sensitive, eked out a 2.7 percent gain during the first quarter, according to fund-tracker Lipper. For the 12 months ended March 31, utility sector funds outpaced the S&P 500 index, returning 21.7 percent versus the S&P 500's 4.8 percent.

A key part of their appeal lies in the fact that utilities are the highest yielding sector of the S&P 500 eligible for the favorable 15 percent federal tax rate on dividends. Payouts on real estate investment trust (REIT) shares, while generally a notch above utilities, don't qualify for the tax break. Besides plump yields ranging from 2.5 to 3.8 percent, shareholders, especially retirees, enjoy the monthly dividend payouts typical of utility funds.

Despite the strong results, utility funds haven't drawn much of a following lately, analysts say. It's an "unloved category that has been experiencing net outflows for many months," notes Morningstar analyst Todd Trubey.

That, in itself, may be good reason for conservative investors to take a serious look at the sector. Morningstar encourages fund investors to place a portion of their diversified portfolios in unpopular funds, specifically stock categories that have had the biggest percentage of outflows during the past year. Based on its fund-flow studies going as far back as 1987, funds that have had the largest percentage of outflows in the past year usually beat the average equity fund during the next three years.

While few analysts expect gas and electric companies to provide better than high single-digit returns this year, the funds may well provide an anchor to windward in stormy seas. "In a volatile market climate where economic growth is likely to slow, you want to have some steady, higher-yielding stocks," says Ronald Sorenson, portfolio manager with W.H. Reaves & Co., an investment management boutique in Jersey City, N.J., that specializes in utilities and other energy-oriented stocks. Mr. Sorrenson sees utilities appealing to investors who seek a rising income stream and modest capital appreciation from a lower-risk portfolio.

A traditional worry about utility stocks during a period of rising rates relates to their sensitivity to interest rates. Since utilities typically carry sizable amounts of long-term debt on their balance sheets, rising rates tend to crimp operating profits. "That's a negative, no doubt," says Judy Saryan, portfolio manager of Eaton Vance Utilities Fund. "Nevertheless ... there's a question as to how much higher long-term rates will go if the economy has hit an oil-induced slow patch and is in a decelerating mode."

Most utility stocks are riskier now, due to deregulation, analysts say. Until the 1990s, most electric utilities were assured a minimum rate of return and earnings by state regulators. Now, dividends are less of a sure thing, and instead of being local monopolies, utilities often have to compete for business.

Still, the financial profile of most of these companies has improved markedly since the California energy crisis of 2000-2001, says Ms. Saryan. Forays into nonenergy areas have been abandoned and utilities are refocusing on their core businesses.