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A Framework To Invest In Utility Stocks

More money has been lost reaching for yield than at the point of a gun. In that respect, as they sift through utilities and try to separate the wheat from the chaff, risk-averse investors would ideally seek companies that combine the eight features that follow.

Earning power: The company holds a diversified, balanced and steady stream of income from long-lived assets that shield its business from hostile regulations, sudden deterioration in the commodity trading markets, climate caprices or unforeseen cataclysmic events.

To that effect, it possesses an adequate operational latitude to switch between production sites and resources, in order to better navigate amid cost fluctuations and other seasonal circumstances.

Pricing power: To strive in a commodity-like environment, the company needs to function as the low-cost operator in a dynamic market.

The best likeable utility sports a specific commercial edge – ideally a monopoly – and nurtures accommodating relations with regulators, upon which it is be able to modulate its pricing power whenever circumstances demand it.

Favorable growth prospects: The company embraces stunning perspectives of growth. To that end, the territory in which it operates is the decisive factor.

If a large exposition to residential service is reputed favorable to earnings stability, it also comes at the expense of future returns. Accordingly, of utmost importance is the rate of industrial growth expected forward for the concerned region.

Financial standing: A demonstrated and consistent earning power shall enable the company to cover its interest requirements under virtually any business environment.

In reflecting its financial standing, a sound equity ratio is equally important, as it suggests a reasonable arrangement of debt and likewise a good credit rating, which accommodates better financing terms for future issues and a less costly expansion of operations.

Insufficient equity handicaps the company, which at some point will deal with the necessity to raise capital, either to fund growth or defend creditworthiness. On the other hand, a bloated equity to total capitalization comes at the expense of future returns.

An optimal balance is thus desirable in theory, but hard to achieve in practice.

Long-term strategy: Whenever necessary, the management should be resolute in withholding earnings for the sake of strengthening the working capital position or increasing the productive capacity.

Ideally, and instead of dilapidating the hardly-earned, thin-margin earnings into lavish dividends, the company retains a sizeable part of the former to fuel growth and build long-term value. For instance, up to 90% of MidAmerican Energy’s – a Berkshire Hathaway subsidiary –  earnings are retained every year rather than distributed.

Value creation: Investors must assess the ability of management to convert growth of revenues into higher per share cash earnings (“free cash-flow”) – an always uncertain prospect in a capital-intensive industry where expansion is primarily driven by large acquisitions or investment projects – through a meticulous study of per share figures over at least an eight years-period.

If a large dividend is paid, the business must justify an impressive showing of earnings history, coupled with commensurate and durable profit margins.

Adequate reserves: The review of accounts has to display evidence of a consistent and symmetrical build-up of both earnings and reserves, the latter being a cardinal indication of future financial stability.

Extra caution must be paid, since certain utilities have mastered the habit of plundering their reserves in order to maintain seductive dividend payout, in essence destroying long-term value to satisfy short-term greed, in which case the principal component of the distributions is not a return on capital, but a return of capital.

Valuation: In this industry, a proper appraisal of fair asset value has such practical arduousness that even experienced managements often fail to achieve the latter at a satisfactory level of accuracy. Thus it is not uncommon, after a discerning examination or unwelcome event, to realize that a particular balance sheet has been copiously “watered” throughout the years, willingly or not.

As a result, investors should not waste time and energy seeking precision in a world that isn’t. Instead, they should rely on a sizeable margin of safety to motivate their decisions. For instance, the ideal investment prospect should trade for a reasonable multiple of its profits, typically in a situation where its true potential for growth is underestimated, or when the impact of acquisitions, divestitures, shares repurchases, debt repayment or refinancing is incorrectly assessed by other investors.

Naturally, such opportunities are most likely to surface in a recessional, high interest rate environment.

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