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Two Utility Stocks for a Rising Rate Environment

Josh Peters, CFA

Josh Peters: Hello, this is Josh Peters. I'm the editor of Morningstar DividendInvestor newsletter.

If you are interested in dividends, chances are you take a look at utility stocks now and again. They've played a big role in producing a lot of income for a lot of retirees and a lot of reinvested dividends for younger savers for many, many decades.

But with interest rates rising, what might that be doing to the utility story? Is this still a good time to buy? Or is it time to sell? Time to hold?

To answer some of these questions, I have brought in Morningstar's senior utility analyst, Travis Miller.

Travis, thanks for joining us today.

Travis Miller: Sure. Thanks.

Peters: So, we've had a pretty big move in interest rates, especially at the long end of the curve. The 10-year Treasury, I think the last time we sat down to talk about utilities was maybe 2.5%, 2.75%. Now we are looking at 3.y5%, a full percentage point move or more.

How much has that really changed the value equation, the value proposition for utility stocks?

Miller: It certainly hurt them relative to the rest of the market. We saw relative outperformance for those higher-yielding names over the first three quarters of 2010, but in the fourth quarter when the rest of the smaller-cap, mid-cap stocks took off in other, high-growth industries, utilities severely lagged the market, and especially those high flyers.

So, now we've seen about flat returns for a good six months or so in this space with the higher-yielding names, and we still think the sector is about 10% overvalued.

Peters: Is there anything that people should maybe be worried about in terms of either valuation--I don't know if 10% perhaps is the kind of level where you get nervous on that alone--or could it be that inflation perhaps being the culprit behind rising interest rates or even just rising interest rates themselves are actually hurting the fundamentals of these utilities' performance?

Miller: Certainly, utilities are highly levered. So, any kind of move up in interest rates is going to hurt the bottom line for them. It's going to raise interest cost. It also makes the dividend yield look less attractive for equity investors.

So, with 4.5% dividend yield on average across that regulated utility space, we still think there are some attractive total returns for investors who might be scared of downside risk, but again rising interest rates always hurt the most regulated utilities.

Peters: So, it sounds like stocks aren't "run for the hills" overvalued by that, perhaps maybe picking individual stocks and trying to maximize value with research is perhaps really important in the sector right now?

Miller: Absolutely. We think that investors need to look for two things right now in utility stocks. One, are they in good regulatory environments where they can adjust very quickly to rising interest rates and additional cash costs. And two, is there growth opportunity? So we need to see growth opportunity from infrastructure investments, particularly in the wires and distribution businesses where you have slight demand growth but also needs to connect environmentally friendly generation and to support the system in general, which is becoming quickly depreciated.

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Peters: Which are the utilities that you cover are still in that undervalued category that you think might be attractive here?

Miller: Our favorite right now is National Grid. So, this is a U.K.-based company, trades with an ADR, NGG is the ticker. Also trades London shares.

We like National Grid because it does have those growth opportunities. So, right now with the 6% yield, which is significantly higher than the average for the regulated utility space, and we think 6% to 8% earnings growth prospects and dividend growth prospects, we think that's a very attractive total shareholder return for a relatively less risky utility stock.

Peters: That is really impressive total return, especially starting off of that 6% yield. Is there anything behind the scenes that perhaps we should be worried about, maybe not take it all for granted?

Miller: National Grid is a combination of U.S.-based regulated utilities, primarily in Northeast, and the U.K. assets. So, the U.K. operations generate about two thirds of operating profit for them.

In the U.S. the one third of operating profit has severely underperformed what we'd expect over the last few years. They've gotten some recent rate increase in those jurisdictions that have helped, particularly in the New York region, and that should boost returns for the U.S. operations, but in general we see pretty laggard growth and laggard returns in the U.S. operations.

Now, the flip side is that we see a lot of opportunity in the U.K. operations and most of what they've announced as a £22 billion investment plan over the next four years is going to go to those U.K. operations with very strong returns and opportunities for dividend growth.

Peters: National Grid certainly sounds like an interesting story. Do you have one more pick that you can share with us?

Miller: On the small or mid-cap end, we like Westar Energy, it's a Kansas-based utility. It's the largest utility in Kansas. We like that, again, for its growth prospects, and its higher-than-average yield for the space. So we're looking at a yield around 5%, and we think growth prospects in that 6% to 7% range over the next five years.

A lot of that growth is going to come from transmission investment. So if we think about the move in the U.S. toward more renewables, wind energy is the primary source of that renewable energy. So as we know in Kansas, very windy place, and it's a great place to build wind farms.

As we need to get that energy from those wind farms in Central Kansas to demand centers such as in Texas or in Chicago, we need to build huge transmission wires, and Westar has the first option on many of those projects and is investing billions of dollars in those over the next five years.

Peters: Also, sounds like pretty good story, if you've got some growth, then perhaps you don't have to think of these as just being bonds and stock clothing that nothing else is going on besides interest rates?

Miller: Sure. That growth element is definitely going to protect you against rising interest rates, and that's the big fear everybody has in a rising interest rate environment investing in regulated utilities.

Peters: The one thing we can be sure of is that if you hold long-term Treasury bonds, you are not going to get any dividend increases or interest rate increases off of those. Those are fixed for the life of the bond. So good way to think about utilities and even some other high-yielding stocks in this kind of environment.

Well, thank you very much Travis.

Miller: Sure. Thanks for having me.

Peters: Thank you for joining us. This is Josh Peters, editor of Morningstar DividendInvestor.