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Our Favorite Utility Plays

Utility stocks are bouncing all over the place.

Most are down 10% or so from their highs. This really has nothing to do with performance, and everything to do with the fear of rising interest rates.

One whiff of a rate increase and the sectors that have been paying steady – and in many cases, rising – dividends are taken behind the shed. I guess making 4.5% to 5.5% on a steady, growing company that has little to no prospect of going out of business just isn’t enough these days.

Investors often forget that utility stocks can provide a good counter-balance to a portfolio loaded up with non-income producing stocks. And what’s more is that many do, in fact, offer upside potential. That’s something many investors don’t realize.

As the economy grows, so does demand for energy. And there are few sources of alternative energy that can compete with the power or gas line coming into your home. Even those that are close to being competitive, like solar energy, are years away from being able to compete absent massive subsidies.

As utility companies modernize, they become more efficient producers and distributors of power, as well. A new plant may cost a few hundred million dollars to build, but the return on investment comes back in half the time it took two decades ago.

Of course, energy prices have the most impact going forward on the fate of utilities. I’m talking specifically about natural gas prices. We’ve been talking about natural gas a lot here at Oil & Energy Daily, and so far we’ve been right on the money, calling the bottom in prices last year and encouraging you to invest in companies like Chesapeake Energy (CHK) long before the market caught on.

Most of the new power plants being built today are going the way of natural gas. It’s plentiful, cheap, cleaner-burning than coal and more efficient. When combined, the efficiencies and the cost savings will mean better margins for power companies and higher profits going forward. Technological advances in meter reading may sound insignificant, but they lead to lower labor costs and higher levels of productivity.

Indeed, utility companies offer a very interesting risk/reward profile right now.

Knowing that the Federal Reserve won’t begin aggressive rate hikes until the unemployment rate drops below 6.5% gives this sector legs – both in terms of a higher dividend than the market in general and the potential for short-term capital appreciation.

Our top picks in the sector are The Southern Company (SO), currently yielding 4.6% and trading 10% below its 52-week high, and Consolidated Edison (ED), trading at around $60, down 10% from its highs as well and yielding just over 4%. Both of these companies have proven track records for growth and raising their dividends. They also service very densely populated areas of the United States.

Our speculative pick for this sector remains Exelon (EXC), which sports a massive nuclear and natural gas portfolio and is in the midst of a turnaround after digesting Constellation Energy. It yields about 4%, but has significant upside compared to its peers.

This Federal Reserve will be remembered for one thing: it’s fondness for “punting” when the markets start to swoon.

It will raise rates at some point, but that point will be long after Bernanke has stepped down. And certainly not before we see GDP growth a full percentage point higher than where it is today and the unemployment rate a full percentage point lower.

Until then, the utility sector is a good place to park some of your cash along with other high-yielding stocks.

And “the chase” continues,

Karim Rahemtulla