After one of the greatest market rallies in history that saw U.S. equities rise 67.8%, emerging market stocks up 108.4% and high yield bonds returning 60.7% off the March 2009 lows, investors are left with some very challenging asset allocation decisions heading into 2010¹. Looking across the investment landscape one area that might be worth a closer look is the utilities sector. With investors favoring early cyclicals and risk assets, the utilities sector lagged the broader market in 2009 by 14.5% and 23.8% off the March lows². However, the market tends to be forward looking in nature, typically discounting company fundamentals six to nine months into the future, keeping in mind past performance is not indicative of future results. Looking out over this horizon, it appears there might be multiple catalysts that may result in an improving environment for the utilities sector. Furthermore, this is at a time where utilities appear to look attractive on several valuation metrics. The following article highlights the characteristics of utilities, what may be some of the key drivers of utilities heading into 2010 and the potential investment options available to investors through Fidelity.

Mature Businesses with Stable Cash Flows

As a brief overview, utilities are those companies engaged in the generation, transmission and distribution of electricity, gas or water. However, the U.S. utilities sector is primarily composed of companies providing power to commercial, industrial and residential consumers. Utilities tend to be focused on delivering power to customers in certain regions of the United States and, as a result, their profits are derived almost entirely from within the U.S. A key distinction among utilities is that some operate in a regulated environment — where a governing authority sets the rates they charge for power — while others operate in a deregulated market — where the laws of supply and demand set the prices for power.

Historically, demand for power has grown at modest levels, similar to that of U.S. economic growth. Given this modest growth profile and the relatively inelastic demand for power, utilities tend to be defensive in nature, with relatively stable cash flows, and have historically done well during recessions, but lagged during cyclical recoveries. Due to this mature growth profile, utilities generally tend to pay high dividends and have well known uses of capital, generally for the maintenance of existing and construction of new power plants. Utilities tend to experience peak performance (i.e. higher growth and margins), later in the business cycle when the economy is on an expansionary path. Now that we’ve talked about the characteristics of utilities and where they fit in the economic cycle, let’s explore why they might be of interest today.

Three Key Drivers for 2010

Looking out over the next several months, there are some broad themes emerging that could potentially positively impact the utilities sector. The first of which is a recovery in power demand. Electricity consumption is tied to the strength of the overall economy and corporate cost cuts — from headcount to production lines — has led to lower electricity consumption in recent years. In fact, power demand declined 1.6% in 2008 and 3.7% in 2009³. This is the first time since World War II that the U.S. has experienced two years in a row of negative power demand growth. But, more recently, improving economic data points have signaled that the economy is recovering and companies are seeing business stabilize and, in some cases, return to growth. One of the key drivers of electricity end-demand is industrial production. The industrial segment is a large consumer of power. Industrial production fell 11.5% from its peak in 2007 through the month ending November 2009⁴ and industrial power demand followed this trend. Industrial power consumption declined 25% from its peak in 2007 to its trough in February 2009³. If that segment of demand improves in 2010, utility stocks could experience a recovery as well. Investors are certainly discounting an improvement in fundamentals for industrial companies as a whole, with the S&P 500 Industrials Sector up 17.3% in 2009 and earnings forecasted to grow 10.9% in 2010⁵. Historically, leading economic indicators have been very good at predicting industrial production, which according to a composite index compiled by the Conference Board saw 80% of its leading indicators rise over the past six months⁶.

As previously mentioned, utilities operate in a regulated or deregulated market. With deregulation, an interesting trend has emerged. Deregulated utilities’ profits have become more closely correlated with the price of commodities, in particular, natural gas. The base level of electricity generation is primarily sourced from coal, hydro and nuclear power plants. However, power demand can vary significantly due to seasonal and economic factors. It is easier for natural gas plants to vary their power generation than other sources and thus natural gas tends to be the source of incremental electricity. As a result, natural gas generally sets the price of power charged to consumers and is highly correlated to the profits for deregulated electric utilities. Natural gas prices tumbled over 80% from peak to trough last year as the weak economy led to an over-supplied market⁷. However, in response to the over-supplied market, drillers cut the active number of rigs drilling for natural gas. In the U.S. alone, the peak to trough decline in the number of active rigs exceeded 55% and recent inventory trends suggest that these massive cuts and an improving economy have led to a natural gas market that is under-supplied and working off excess inventory⁸. This has improved the outlook for natural gas, which has experienced a price increase of over 130% in the past four months. Any further increases in natural gas would bode well for the future earnings power of many of the deregulated utilities.

Another key driver for utilities is that valuations are inexpensive relative to history, both on an absolute basis and when compared to other asset classes. Compared to the U.S. Corporate Investment Grade Bonds Index, the dividend yields on utilities are almost on par with the yields on bonds — historically they’ve traded at a discount. The group also has very attractive gross cash flow yields and is trading at a discount relative to the market on trailing earnings. Furthermore, given that market participants have experienced two roughly 50% cuts to their wealth tied to the stock market over the last decade, investor risk appetite has decreased. This was very apparent in 2009, when inflows into bond funds totaled $349 billion versus a $7.7 billion outflow from equities⁹. Combined with a low interest rate policy from the Federal Reserve, these massive inflows into bond funds have driven the yields on investment grade securities to their lowest point in over thirty years. It’s possible that many yield-oriented investors may eventually look for a place to earn a high rate of return. Given their attractive dividend yields, the utilities sector could be one area that investors potentially look to. Additionally, due to the sector’s defensive profile, utilities could be a lower-risk alternative to the broader stock market if the economy experiences another leg down or market volatility were to spike, which some investors fear may potentially occur in 2010.

While there are several potentially positive catalysts for utilities on the horizon there are also some risks to the utilities. Any meaningful derailment in the economic recovery could potentially weigh on industrial power demand, which would equate to weakness for the group. Additionally, given that investors view utilities as yield-oriented investments, a rise in interest rates could also hurt the group. This is because after rates rise, yield-oriented investors may opt to rotate into bonds. With that being said, any future increase in rates could negatively impact most yield-oriented investments. In summary, the utilities sector was shunned by investors in 2009 as they generally favored higher risk assets with more cyclical qualities. However, this has resulted in attractive valuations for utilities on both an absolute and relative basis.

When pairing their high yields, stable business models and an outlook for potentially improving industrial power demand and higher natural gas prices, the utilities sector could be worth a closer look.

How to get Utility Exposure

For investors interested in gaining exposure to the utilities sector, Fidelity offers the Fidelity Select Utilities Portfolio, which is an actively managed fund focusing exclusively on utilities stocks. Additionally, Fidelity offers the Fidelity Telecom and Utilities Fund, which has averaged an allocation of 53% to the utilities and 38% to telecom investments over the past five years. Focusing on Select Utilities, the fund’s portfolio manager, Douglas Simmons has been managing the fund for over three years and had experience investing in and analyzing companies in the utility and energy sectors prior to his current role. Douglas’s approach to investing in the group is rooted in detailed fundamental analysis and frequent contact with the management teams of the various utilities serving the U.S.