By JACK HOUGH
Investors who are worried that stocks have risen too far, too fast, should give utilities another look.
Shares of electricity and gas companies typically offer generous dividend yields -- dividend payments as a percentage of stock price -- and slow but steady growth.
Yet after a strong 2011, the sector has missed out on this year's rally, slipping 2.3%, including dividends, while the Standard & Poor's 500-stock index is up 12%.
Why such a big gap? Lower jobless claims, renewed manufacturing activity and other signs of recovery are sending investors toward sectors tied more closely to swings in the economy than utility stocks. Technology stocks in the S&P 500 have soared 20% so far this year, for example, and consumer-discretionary stocks such as Amazon.com (AMZN)
Utility stocks also are seeing profits pinched by an unusual set of supply-and-demand factors. Mild winter weather caused U.S. households to use 9% less electricity in January and February than during the same period in 2011, according to the Department of Energy.
Meanwhile, new drilling technologies have unlocked vast amounts of natural gas from U.S. shale deposits, pushing natural-gas prices to a 10-year low. While that is a boon for power generators that use natural gas to produce electricity, cost pressures are mounting for a large portion of the industry that still relies heavily on coal.
"We've never seen natural gas cut into coal like this," says Maura Shaughnessy, manager of the MFS Utilities
In recent years, utilities have gotten cheaper relative to the broad market. They make up 3.4% of the S&P 500's market value today, versus 4.4% three years ago.
Over the long term, profit margins for the sector are likely to recover, says Douglas Simmons, a portfolio manager at Fidelity Investments, as more power production shifts from coal to natural gas, pushing costs lower.
Electricity generation from coal was down 21% year over year in December, the latest month for which data are available, according to the Energy Department. Electricity generated from natural gas was up 12% over that period. Coal's share of U.S. power output fell below 40% in November and December, a level unseen since March 1978.
Meanwhile, utilities' dividend yields have stayed relatively plump. The S&P 500's yield recently slipped to 1.9%, while the 10-year Treasury yields 2.3%. But investors can get 3% to 4% yields with low-cost exchange-traded funds that offer broad exposure to the utility sector, such as iShares Dow Jones U.S. Utilities Sector Index (IDU),
As utilities adapt to changing conditions, investors should expect their earnings to rise by 4% to 6% over the next several years, with similar growth in their dividend payments, says Timothy Winter, a utility analyst at Gabelli & Co., an asset manager.
Be warned, though: In the short run, some utilities will have to spend more than usual to upgrade their plants. The key for stock pickers is to determine not just which utilities will spend the least, Mr. Winter says, but which ones are likely to get the largest profit boost from the money they spend.
He likes Southern Cos. (SO),
MFS's Ms. Shaugnessy likes Public Service Enterprise Group (PEG),
Investors who prefer actively managed funds over ETFs should be careful: The two top-performing utility funds from past year aren't necessarily the best picks now, says Morningstar (MORN)
One is ProFunds Utilities UltraSector,
A better bet going forward, Mr. Kathman says, is Franklin Utilities,
MFS Utilities, Ms. Shaughnessy's fund, has 16% of its portfolio in utilities based in emerging markets and 17% in Europe, including the U.K. That was a heavy drag on returns last year because those regions performed poorly amid a fiscal crisis in Europe and slowing growth in China. But over the past 10 years, the fund has returned 11.4% a year, ranking it among the top 3% of its peers, according to Morningstar.
Ms. Shaughnessy's favorite non-U.S. picks include CEZ Group, a Czech electric company serving Central Europe, and Energias de Portugal, which has electric and gas operations in Europe and Brazil. The two stocks yield more than 6% and 7%, respectively.