Utility stocks may outdo the markets for the next few years. But not all companies in this sector will thrive. Here’s how to pick the likely winners.

Utility stocks are a traditional haven when fear rules the stock market. The sector has certainly worked that way since March. Since the low in the Dow Jones Utility Average ($US:UTIL) on March 28 — roughly two weeks after the Dow Jones Industrial Average ($INDU) put in a temporary bottom March 10 — through the market’s close on July 10, the utility sector has climbed 10%. In that same period, the Dow industrials are down 8%.

With the bear market still raking its claws through portfolios, getting that kind of performance and safety is obviously an attractive option today.
But there are other reasons to buy utility stocks now that make some of them a long-term growth story:
• Soaring energy prices.
• Impending energy shortages in major regions.
• The ending of a long period of chronic underinvestment in the distribution grid.
• Likely action to tackle global climate change.

Over the next five to 10 years, these electric utilities could well match or better the return on the major market indexes with less than market risk. Not all utility stocks will share that good fortune. Some, in fact, will be victims of the same trends that will lead to outperformance by their peers. Over the next five years, the difference in performance between the right utility stocks and the wrong utility stocks is likely to be huge.

So how do you get on the right side of that performance story? I’ve got five simple steps to follow. I’ll lay them out below. And then I’ll end the column with three picks from the sector. One of them is already a Jubak’s Pick. I’ll add another utility stock to the portfolio with this column.

• Step 1: Look beyond yield. Utility dividends are important in the short run, so I wouldn’t ignore them completely. The 2.2% dividend paid by Exelon (EXC, news, msgs), for example — just slightly less than the yield on a two-year Treasury bill — is one reason the stock has held up so well in a bear market. But for the long term, a high dividend may be exactly what you want to avoid and a low dividend exactly what the market ordered.

• Step 2: Look for utilities adding assets to their rate bases. Regulators set the revenue a utility can collect based on a set percentage return on the value of its assets. Thus the more valuable a utility’s assets, the higher its revenue. For the long run, then, you’d like to find a utility that’s adding power plants, power lines and other assets to its rate base. A utility investing in assets for the future, however, may not be able to pay much of a dividend now, which is why a low current dividend may be exactly what you’d like to see.How long will the economic slowdown last? That’s the most important question facing investors. Unfortunately, the numbers show the credit crunch is still getting worse, Jim Jubak says.

• Step 3: Look for state utility regulators that reward utilities for adding assets. A regulator doesn’t have to give a utility a market rate of return on its assets or include all of the utility’s new assets in its rate base. The regulator could find, for example, that the proposed — or worse yet, recently built — power plant isn’t justified by current forecasts for electricity demand and refuse to put part or all of it into the rate base. That could kill a utility’s return in the near term and discourage the company from investing to meet future needs. What you’d like to find are state regulators who recognize that the utility industry faces a crisis. Years of underinvestment in the grid and distribution system have left utilities unable to get power where it needs to go with any kind of efficiency. Many states are also now looking at significant shortages of electricity in the next few years because utilities haven’t invested in enough power plants. As an investor, you want to find a combination of a utility and a utility regulator that both recognize the need for big investments in capacity and distribution now.

• Step 4: Look for utilities with the right mix of assets and assets under construction. One of the reasons that I had added Exelon to Jubak’s Picks is that the company owns 17 nuclear units that generate about 18% of all electricity generated by nuclear power in the United States. As the cost of coal, natural gas and oil rise, those nuclear plants get more and more valuable, because they generate electricity at about half the cost of the most efficient coal-burning plant. And they generate that electricity without producing any greenhouse gases. Any scheme to tax, regulate or cap greenhouse gas emissions will just increase Exelon’s cost advantage. Other types of assets that investors want to own for the long run include wind power farms, solar power plants and smart grids, which let a utility manage demand on its system to minimize the use of expensive peak-power generators.

• Step 5: Avoid utilities with the wrong assets. Whether the next administration decides to tax carbon admissions, regulate them, cap them or set up a market to trade them, utilities that use coal to generate electricity are looking at rising costs. That’s going to spell the death of the 20% or so least efficient coal-burning plants in the U.S., according to estimates by utility Edison International (EIX, news, msgs). The utilities that own those plants will either see their rate bases — and thus their revenue — fall or have to spend lots of cash to build plants at a time when construction costs are rising at better than 15% annually.

Let me give you three electric utility stocks that fit those five rules:
• Edison International. The company owns some of the most efficient coal-fired power plants in the country. It has made a major investment in improving its transmission system and projects it will invest an additional $5 billion in transmission over the next five years. Edison is also investing to extend the life of its San Onofre, Calif., nuclear plant, is implementing one of the country’s largest smart-meter installations, has announced plans to add 250 megawatts of solar-generated electricity by installing thin film solar panels on rooftops in its Southern California service area and has work under way on 17 wind farms. All of which are investments that the California Public Utilities Commission has aggressively encouraged — because California faces severe future shortages of electricity and an inadequate system for getting what electricity there is to the right places — by adding these projects as completed to the company’s rate base. The state Public Utilities Commission has set the company’s recent return on equity at 11.5%. The company has roughly $20 billion in spending in its current capital plan. That’s enough, Edison calculates, to increase the rate base about 12% a year through 2012. The shares currently yield 2.4%. I’m adding Edison to Jubak’s Picks with this column. (As part of my plan to keep cash in the portfolio near 30%, I will look for a sell to balance this buy in the next bear market rally.)

• FPL Group (FPL, news, msgs). I’ve written about this utility before. The Florida utility is the leading producer of wind power in the United States, with about 30% of the market. At the end of 2007 the company owned 5,100 megawatts of wind-generating capacity. The company plans to add 8,000 to 10,000 megawatts from 2007 through 2012. FPL is also the country’s largest generator of electricity from solar thermal power plants. (These plants use sunlight to heat water that then runs turbines that produce electricity rather than generating power from panels of photovoltaic cells.) And it’s the fourth-largest producer of electricity from nuclear power in the country. The shares yield 2.6%.

• Exelon. As I wrote when I added this stock to Jubak’s Picks on Jan. 15, the company’s 17 nuclear units ran at a record 94.5% average capacity in 2007. The company clearly thinks the good times will last for a while: It raised its dividend by 14% at the beginning of 2008. The shares yield 2.2%.
You can earn a higher dividend yield with other utility stocks, but these are the three that best combine current safety and not to be undervalued in a bear market, with the potential for high future earnings growth.

Update to Jubak’s Picks
Buy Edison International (EIX, news, msgs): The company has about $20 billion in capital spending scheduled through 2012. That, the company calculates, is enough to keep the rate base growing by about 12% a year during that period. Making new investment in 17 wind farms, extending the life of its San Onofre nuclear power plant, adding 250 megawatts of solar power and upgrading its transmission and distribution networks will further diversify the utility’s sources of electricity. Edison already owns some of the most efficient coal-fired power plants in the country.

I’m adding Edison to Jubak’s Picks with a December target price of $61 a share. (Full disclosure: I will buy shares of Edison for my personal portfolio three days after this column is posted.) Developments on a past column “Inflation from Asia: