Prudish Utilities Are Prudent Investments

Well, you wouldn't call this investment arena “sexy.” In fact, it's downright prude. But when the stock market acts the way it has lately, I’ll take prudish and prudent over sexy and scintillating any day.

I'm talking about utilities. They plod along, dishing out dividends and turning a deaf ear to all the noise happening on Wall Street. They’re usually steep in tradition and centuries old.

The York Water Company (NASDAQ: YORW) is almost 200 years old. It distributes water in York and Adams Counties in Pennsylvania. York owns two reservoirs, Lake Williams and Lake Redman, which together holds approximately 2.2 billion gallons of water.

York Water has recently completed a supply security project a 15-mile pipeline from the Susquehanna River to Lake Redman that provides access to an additional supply of 12.0 million gallons of water.

This is a small utility and it has about 60,000 residential customers and generates about $500 per customer in revenue. This $160 million company has an operating margin of 43% with a forward P/E of 21. York Water Company’s claim to fame is that it hasn’t missed a single dividend payment in more than 100 years.

Unlike their larger peers, more than a third of the shares of these small-cap utilities were held by hedge funds in early 2008, according to InsiderScore.com. For instance, Horizon Asset Management's stake in NV Energy (NYSE: NVE) went from nearly 30% in mid-2008 to around 5% last month.

Forced selling by hedge funds, in order to meet margin calls and shareholders' redemptions, spurred declines in these utility stocks. When hedge funds sell stocks for reasons having little to do with the fundamentals of the stocks themselves, it can create opportunity for investors.

Michigan’s CMS Energy (NASDAQ: CMS) and NV Energy operate in regions that have above-average unemployment rates. Michigan is the home of Detroit's beleaguered auto industry, and Nevada has the highest level of home foreclosures. Electricity sales could fall by up to 3% for both companies in 2009.

Even so, both utilities are well positioned in this recession, thanks to a more favorable regulatory environment and the ability to recover costs from investments. Provisions allow utilities to raise rates several months after requesting increases.

Lower commodity prices, which are passed through on bills, will ease pressure on consumers' wallets. Both companies are also boosting initiatives to conserve energy and generate more power from renewable sources, which are considered Washington's priorities. CMS Energy plans to earn 10% of sales from renewable electricity (primarily wind power) by 2015, up from 4%. NV Energy expects to raise its renewable exposure from 9% to 12% this year mainly through solar and geothermal production.

Analysts project NV Energy's long-term earnings growth rate at 13% a year, according to Thomson Reuters. CMS Energy's target annual growth rate is 6%-8% through 2013. Both companies also plan to continue raising their dividends.

NV Energy's dividend yield is 5% and CMS Energy's yield is 4.7%.

Yet, shares of both companies are trading at a sharp discount to their peers. On average, regulated utilities are trading 1.2 times book value; CMS Energy is going for 0.7 times and NV is at 0.6 times.

At CMS Energy, electric and gas utilities make up 95% of the business, with the rest coming from natural-gas storage, transmission and other activities. The company has asked Michigan regulators to decouple its profits from power usage, which would make it more defensive if the measure is approved.

Meanwhile, NV Energy is facing a multitude of economic headwinds from serving the gaming industry in southern Nevada and miners in the north.

To be sure, both utilities face great economic headwinds. But their operations are still fairly defensive and the ravaged stocks offer tremendous value for long-term investors.

Aqua America (NYSE: WTR) is a water utility in the United States. It provides residential, commercial, fire protection, industrial, and other water and wastewater services to 3 million customers in 12 different states. Aqua America has a forward P/E of 21 (a bit high, but in line with its long-run average). In August 2007 it was trading at a high of $25, and it is now trading at $17.  As investors seek safety and run from financials, I expect a good bit of the “safe” money to flow into water.