Investing in the "Plain Vanilla" Utility

During the high-flying days of the power generating-power trading bubble, when prices skyrocketed and wheelers dealed, utility managers and investors looked down on the dull, regulated wire businesses. Why settle for low returns when riches beckoned? Why run a slowly growing regional bureaucracy when one could become a globetrotting empire builder? Why pay dividends when one could invest the money in assets? Dump those dividend-seeking elderly shareholders and turn the company into something exciting! The morning after the binge has dawned in both the power market and the financial world. After a two-year bear market, investors have jettisoned the dogma of the new economy. Financial experts now talk about lower expectations. Dull, safe investments might again attract capital. Can electric company managements fashion distribution-oriented businesses that will produce the returns needed to attract capital? They can now because the market is no longer dismissive of the low returns associated with low risk, considering that the high-risk investments so popular in the recent past produced high losses instead of high returns. I. OVERALL EXPECTATIONS FOR THE MARKET To answer the financial aspects of that question, let us first examine investor expectations. If investors continue to expect high levels of profit in the market (akin to the 30% per year they made in 1995-1999), they will avoid utility-type shares, because they know for sure that regulated companies cannot earn the returns necessary to generate those profits to investors. (During that period, electric utility shareholders earned only 9% per year, despite a marked drop in interest rates.) Company managements, for that matter, will not embark on a low-risk and low-return course of action if they believe they can do far better by taking greater risks.1 For at least 80 years, investment professionals and academics have tried to quantify the market performance of stocks and compare it with that of bonds.2 In 1955, economist Ezra Solomon examined another issue, the real growth in stock prices versus the real growth of the economy.3 Using 1874-1955 data, he concluded that stock prices (as measured by the S&P Index) grew (in real terms) at two-thirds the rate of the gross national product. After the development of modern portfolio theory in the 1950s and 1960s, academics attempted to measure an equity premium, that is, the return above the risk-free rate that common stock investors desire to earn. In a pioneering study, Fisher and Lorie showed that, in 1926-1960, common stocks produced a nominal annual return of 11.2% versus an ill-defined government bond return of about 4%.4 Subsequently, Ibbotson and Sinquefield launched a series of studies that quantified returns on stocks and bonds. (Table A) Those studies probably led to the notion that common stockholders expected to earn (in real terms) roughly 6% more from common stock than from risk-free Treasury bills, and roughly 4-5% more than from bonds. Ibbotson and Sinquefield even made projections of return based on their studies. (Table B) The action of the stock market from the late 1980s to the late 1990s seemed to confirm the notion that equity investors should expect to earn at least five percentage points more than bond investors. If anything, the proponents of the new era concept would have argued that shareholders should expect a far greater profit differential by investing in stocks. Recently, however, academics and investment professionals have begun to pull apart the old analysis. Arnott and Bernstein, for instance, examined stock prices, dividends, and the Gross Domestic Product (GDP).8 They found in real terms that stock prices tracked per capita GDP over time, dividends accounted for a large percentage of real return earnings, and dividends grew more slowly than one should have expected given the reinvestment rate, bond yields (the benchmark for the measure) stayed low because bond investors persistently underestimated inflation, and rising stock valuations (higher price-earnings ratios) in the latter part of the last century raised the realized return on equity investment. …