“A simple-appearing concept usually carries a number of paradoxes and pitfalls.” (The New Speculation In Common Stocks, 1958)
If more money has been lost reaching for yield than at the point of a gun, the utility companies and the liberal dividend policy they traditionally practice are condemned to set an ideal stage for the happening of a soft yet perfect robbery.
In the field of investing, as elsewhere, nothing is more deceptive than an obvious fact. In that respect, and bearing in mind how the devil made a sinful habit of hiding into the details, defensive investors would seek an utility company that effectively cumulates the ten features listed below:
June 16, 2013
(1) The company holds a diversified, balanced and steady stream of income from long-lived assets that shield its business from legislators’ hubris, sudden deterioration in the commodity trading markets, climate’s caprices or unforeseen cataclysmic events.
To that effect, the utility possesses an adequate operational latitude to switch between production sites and resources, in respect of cost fluctuations and other seasonal circumstances.
(2) To strive in a commodity-like environment, the company would need to function as the low-cost operator in a market immune of erratic buying capacity.
Consequently, the best likeable utility would sport a specific commercial edge – ideally a monopoly – and nurture accommodating relationships with regulators, thereupon it would be able to modulate its pricing power whenever circumstances demand it.
Although decisive, this factor cannot be captured by a single quantitative study of the business’ metrics. On that account, to estimate the future earning power of an utility is at least two – if not three – parts art for every one part science.
(3) Its demonstrated and consistent earning power shall enable the company to cover its interest requirements under virtually any business environment.
In reflecting its financial standing, a hefty equity ratio is equally esteemed. It suggests a reasonable arrangement of debt and likewise a good credit rating, which accommodates better financing terms for future issues and a less costly expansion of operations.
However, a bloated quotient to total capitalization comes at the expense of future returns, as it may prevent a compelling accretion of share earnings.
Reciprocally, an insufficient equity handicaps the company, since it will sooner or later wind up facing the necessity to raise capital – either to fund growth, defend creditworthiness or appease regulators – diluting current stockholders’ interest on the same occasion.
A thoughtful balance in the capital structure is thus needed.
(4) The management would not be shy of withholding earnings from shareholders for the sake of strengthening the working capital position or increasing the productive capacity.
Ideally, and instead of dilapidating the hardly-earned, thin-margin proceeds into lavish dividends, the company would retain a sizeable part of the former to fuel growth and build long-term value.
Submitted herewith is an excerpt from a preeminent American utility’s record – earning power stands remarkably consistent, while retained earnings amount to 93% of revenue and surplus remains sanctuarized.
surplus op.income retained
2008: 5,455 12,668 5,631
2009: 5,453 11,204 6,788
2010: 5,427 11,127 7,979
2011: 5,423 11,173 9,310
2012: 5,423 11,548 10,782
(5) Hence, the investor must gage the ability of management to convert growth of revenues into higher per share earnings and net asset value – a quite uncertain prospect in an industry for which expansion is primarily driven by steep acquisitions – through a meticulous study of per share figures over at least a seven years period.
If a dividend is paid, the business must justify an impressive showing of earnings history sheltered by commensurate and durable profit margins.
(6) The review of the books has to display evidence of a consistent and symmetrical build-up of both earnings and reserves, the latter being a cardinal indication of future financial stability.
If the company shows a positive income but a decline in reserves, chances are that a loss has shamelessly been transferred to surplus. Deductions to reserves – which customarily comprise such item as property retired – thus need to be thoroughly scrutinized in order to ensure that earnings have not been inflated.
Neither is it rare that certain utilities purposely plunder their reserves in order to maintain seductive dividend payout, destroying long-term value to satisfy short-term greed, in which case the principal component of the distributions is not a return on capital, but a return of capital.
As a consequence, elementary prudence entices the investor not to exaggerate the significance of a single year’s earnings, but instead to pay special attention to the surplus account and its profits and losses run-down over the course of several exercises.
(7) The business must generate substantial cash returns on its operating assets.
Indeed, if the book value of a security is in most cases a rather artificial value, in no other field – besides financials perhaps – does the proper appraisal of a company’s assets true worth have such practical arduousness than with the group of utilities.
Measuring the precise current value of large facilities and complex machinery is a Herculean, seemingly vain endeavour that even experienced managements often fail to achieve at a satisfactory level of accuracy. Thus it is not uncommon, after a discerning examination, to realize that a particular balance sheet has been copiously watered.
As a result, to deduct the tangible value of the business – and thereafter assess a judicious price to acquire it – does chiefly depend upon the cash yielded by the assets at work. A figure above 10% would qualify the utility as an exceptionally managed enterprise.
The customary approach to valuing utility stocks is to employ the dividend discount model. Yet in light of the innumerable disillusions experienced by individual and institutional investors alike, the adherence to this method persists rather hazardous, to say the least.
(8) In theory there is no difference between theory and practice, but in practice there is – the popular burlesque sums up well the abstruse issue of estimating amortization and depreciation costs of utilities for the long-run.
In view to limiting the analytical strain without giving up caution, applying the old yardstick of 15% of gross as an intangible allowance for devaluation of assets shall offer a sensible margin of safety and a handy way to sweep potential ventures.
(9) The operating liquidity requirements of utilities are typically less intensive than in the case of industrials, since it has been customary to provide for expansion by means of new financing rather than out of surplus cash.
Inasmuch as an ounce of prevention is worth a pound of cure, the ideal investment prospect notwithstanding shows a comfortable working capital throughout the various fiscal exercises.
(10) Finally, the company would of course embrace stunning perspectives of growth. To that end, the territory in which it operates is the decisive factor.
Although a large exposition to residential service is reputed favourable to earning stability, it comes at the expense of future returns as well.
Accordingly, of utmost importance is the rate of industrial growth expected forward for the concerned region.
At that point, the agnostic reader ought to inquire if such an outstanding utility company does truly exist. Let us answer by the affirmative but remark that, alas, Berkshire Hathaway has already snapped up all the shares.
As its chairman opined, however: “Owning utilities isn’t a way to get rich; it is a way to stay rich.”