Buy These 3 Stocks for a Utility Power Play

by Johnson Research Group | September 24, 2012 10:54 am

After a strong first half of 2012, utilities have spent much of the summer months lagging the market amid apparently waning disinterest.

Looking over the last few years, this unexciting sector has been the tortoise in the investing race; the Select Sector Utility SPDR (NYSE:XLU[1]) has posted returns on par with the S&P 500, with XLU’s lower volatility and higher dividend yield presenting a portfolio value that the S&P doesn’t.

In contrast to the long-term performance of utility stocks (or the “utes”), however, the past three months have seen the group lag the S&P 500 by a large margin, putting the XLU shares at the bottom of the performance list for widely traded ETFs. The shift has investors asking “Why the change?” and “Is it time to throw the utes out of my portfolio?”

Let’s answer these questions separately, starting with “Why the change?”

As most investors know, the summer months have been good for the market, contrary to the usual seasonal trends. With the S&P 500 trading 4% higher since the beginning of May, it would appear that the “risk-on” trade is now in effect.

Given the defensive nature of utilities, it is only natural that when the market starts taking more risks, investors move away from these stocks — that, in our opinion, explains utilities’ recent underperformance.

There’s another factor at play. Utility stocks are a favorite destination for investors looking for dividend yields. With interest rates as low as they have been, the utility stocks attracted income investors over the last year or so — so much so that it created a small “bubble” among all high-yield stocks. Recently, though, we’ve seen a lot of profit-taking from high-yielding stocks across all sectors.

But given the continued low-interest-rate environment, we continue to believe that investor interest toward dividend plays will remain high, suggesting that the pullback in these stocks is more likely to result in a buying opportunity for savvy timers.

So, given the market’s continued volatility and this low-interest-rate environment, the answer to the second question — “Is it time to throw the utes out of my portfolio?” — becomes easier to answer.

The pullback in the XLU and its component companies is providing an opportunity for those that like to buy on dips. Still, right now, we suggest you stick with the “best of breed approach.” Let’s take a quick look at the relative strength leadership of the XLU companies. The table below displays the top 10 utility companies based on the last three months of returns:

In our opinion, you don’t need to look any further than this list to find potential at the individual stock level. Let’s take a quick look at each of these companies:

NRG Energy (NYSE:NRG[2]): This utility company is an integrated wholesale power generation and retail electricity provider that focuses on the operation of power generation facilities. Since mid-August, NRG prices have consolidated at the $21 level while the majority of utility companies have retraced lower. The technical strength of NRG shares is likely to draw even more buyers when utilities pick up steam again. We like the stock at its current levels, as well as its chances to move toward a price target of $25 by year’s end.

Oneok (NYSE:OKE[3]): Oneok engages in the gathering, processing, storage and transportation of natural gas and natural gas liquids. With natural gas in an intermediate-term bullish uptrend, natural gas providers should have their wind at their backs as we head into year’s end. OKE shares are consolidating at $47 for the last week after a quick ascent from $46. Only 64% of analysts rank the stock a buy. We like this, as it leaves room for upgrades to move OKE shares higher. Look for OKE to break the $50 level in the near-term as the shares push to new highs.

American Electric Power (NYSE:AEP[4]): AEP’s business focuses on the generation, transmission and distribution of electric power to the retail market. Its electricity is generated through use of coal, natural gas, nuclear energy and hydroelectric energy. At $42, AEP shares are trading only 5.7% higher for the year, but the trend is clearly becoming the shares’ friend lately as a strong intermediate-term trend has emerged.

We like AEP shares given their trend, but there’s more. Short interest on AEP has shot to its highest level in two years as short sellers are increasing their bearish bets. This, of course, increases the odds that we could see a short-squeeze rally. Secondly, only 57% of the analysts covering the stock have ranked it a buy. Just like OKE, this means we could see analyst upgrades over the short-term. The charts suggest some resistance at the $44 level, which AEP shares are in the process of breaking above right now. A successful break of the $44 level will likely give way to a run to $50 before year’s end.

As of this writing, Chris Johnson did not hold a position in any of the aforementioned securities.

  1. XLU:
  2. NRG:
  3. OKE:
  4. AEP:

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