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Utilizing Utilities’ Total Return

These bargains offer robust dividends and room for price appreciation.

John Zecy, 10/16/2013

This article originally appeared in the October/November 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.  

With the S&P 500 breaking 1,700 points in August to reach its all-time high, some investors are becoming skeptical of the market’s capacity for capital appreciation and are favoring dividend-rich stocks. Nevertheless, we think the outlook for equity markets is still promising over a longer time horizon with pockets of undervaluation available for investors to realize healthy returns.

That said, we decided to please both tastes by running a screen for regulated utilities. In addition to the sector’s traditionally robust dividend yields, we have identified a few bargains that can provide investors with some sizeable price appreciation.

Sector = Utilities
And ( Economic Moat = Narrow
Or Economic Moat = Wide )

At Morningstar, we assign a firm an economic moat rating based on two primary attributes: the prospect of earning above-average returns on capital and a competitive edge that prevents these returns from quickly eroding, earned through high switching costs, a cost advantage, intangible assets, a network effect, or efficient scale.

We primarily award economic moats to regulated utilities that enjoy an efficient scale effect with a difficult-to-replicate infrastructure network that delivers essential sources of electricity and natural gas. Federal and state laws tend to grant significant protection that develops these firms into natural monopolies, which in turn ensures an economically efficient energy delivery system. While these regulations also largely determine utilities’ returns, they are set at a level that aims to keep customer costs low while providing adequate returns for capital providers. These implicit contracts between regulators and the utility should, in the long run, allow the firm to earn its cost of capital.

And Morningstar Rating Overall >= 4

While a utility company may display strong competitive advantages, we want to ensure that the market has not overpriced it relative to what we believe is its fair market value. For this we used the Morningstar Rating for stocks, setting the screen for companies with at least a 4- or 5-star rating.

John Zecy is an associate equity analyst at Morningstar.

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