Utilities: Diamonds in the Rough?

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The recent market rally has made superstars out of once-bludgeoned stocks, as money has poured into sectors that have taken the biggest shellacking. Companies like Wells Fargo (NYSE: WFC  ) and Aflac (NYSE: AFL  ) have both tripled from their 52-week lows.

Although it would have been nice to catch these risers before they caught fire, Foolish investors know that fortunes are made through disciplined, long-term investing focused on a company's fundamental value. Today's lump of coal could be tomorrow's diamond in the rough.

Speaking of which ...
One area that I've looked at closely lately is the utility industry. Typically seen as defensive stocks for their bond-like returns on capital, euphoric investors have largely ignored utility companies during Mr. Market's recent run-up. Established companies trading at low multiples to earnings and paying nice dividends like Consolidated Edison (NYSE: ED  ) , Southern Company (NYSE: SO  ) , and First Energy (NYSE: FE  ) are still close to their 52-week lows.

Unlike the more typical free-market industries that most investors are familiar with, where supply and demand set the price of a product and service, utilities operate as monopolies in the highly regulated segments of the electricity, natural gas, and water markets. Often, regulators set both prices as well as acceptable returns on investment for capital projects.

How utilities grow
In order for a utility to grow its capital base and subsequent earnings, it must demonstrate a need for capital-intensive projects and get approval from the regulating body. Based on this premise, the two most important factors to consider when investing in a utility company are future capital investments and the regulatory environment.

If a utility company is governed by a very shareholder-friendly regulatory body but has no need for new capital investments, it won't see its earnings grow. Conversely, a utility with a need for capital investments governed by non-shareholder-friendly regulators will have trouble getting approval to build new projects and will thus run into the same problem.

Is growth coming?
The good news for utility investors is that support for capital-intensive projects may be right around the corner. Initiatives like the American Clean Energy and Security Act of 2009, for instance, will require many utility companies to build new transmission lines in order to deliver newly built alternative energy generation from its remote location to the load centers where people live. The bill also proposes a carbon cap-and-trade program which will encourage utilities to replace older carbon-emitting generation plants with new clean energy sources.

So, which utility companies stand to benefit the most from the push for clean energy? Consolidated Edison has already announced plans to invest $1.5 billion in their transmission system this summer, and other utilities in the northeast, such as Boston-based NSTAR (NYSE: NST  ) and Connecticut-based Northeast Utilities (NYSE: NU  ) , are sure to follow suit. On the generation side, companies like Southern Company, which operates in the investor-friendly state of Georgia, rely heavily on coal-fired power, which may need to be replaced by new clean energy technologies.

With the market's current distaste for defensive stocks and long-term tailwinds like the clean energy movement, putting your money into shares of utility companies with a growing population and shareholder-friendly regulators could prove to be a gem of an investment.

More on utilities:

Southern Company is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Elliott Orsillo has an affinity for all things energy related. He does not own shares in any of the companies in this story. The Fool has a disclosure policy. 

Read/Post Comments (3) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 01, 2009, at 3:44 PM, mpendragon wrote:

    If CAPS factored dividends into the scoring model (the weighted average of the S&P dividends calculated quarterly) I'd be more apt to pick a few utilities. In theory the market should take care of that but it would be a nice thing to include directly.

  • Report this Comment On June 01, 2009, at 4:28 PM, greenwave3 wrote:

    Don't forget about Allete (ALE). Probably one of the most fundamentally undervalued utilities out there.

  • Report this Comment On June 01, 2009, at 10:09 PM, greenwave3 wrote:

    Allete is one of the only American utilities with a debt/equity ratio below 1...

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