Southern Company: Our Top Pick Among the Utilities

Here's a pop quiz for you:  What are the yields on 10-year and 30-year US Treasury bonds?  Unless you are an extremely keen observer of the bond markets, my guess is you will be shocked to learn that 10-year US Treasuries now yield only 1.80% and 30-year Treasuries are yielding a paltry 2.9%.

Just think of it, if you want a supposedly risk-free investment, the highest rate available is under 3%, and to get it you have to tie up your money for 30 years and pay taxes on the income.

Rates have fallen to these levels as a result of the Federal Reserve's attempts to stimulate the economy.  In driving rates to such low levels, the Fed is essentially trying to force investors to look away from Treasury bonds toward other investments that offer a better return.  We think it will work.

The chart above shows our 20 year Dividend Valuation Model for Southern Company (SO).  The chart clearly shows that SO's price (red line) and value (blue bars) have moved in close proximity over this time frame.  The statistical correlation is above 80% and suggests that SO is approximately 25% undervalued.

Southern is one of the country's biggest and best run utilities. You might call it the Sunbelt's power company because it serves most of the southern half of the United States east of the Mississippi River.  This is key to it long-term prospects.  It is well-know that the Sunbelt climate is popular with both people and businesses.  There has been a steady migration of both into the region for the last 30 years.

We believe one of the first places investors will look as they move away from bonds is at utilities.  Utilities offer high dividend yields, dividend growth, some governmental protection, and provide a service that is essential to our way of life.  Here's the bottom line on Southern Company.

1. SO's current dividend yield is 4.5%, much more than the aforementioned Treasury bonds.
2. They have paid a dividend since 1948
3. They have increased their dividend for nine consecutive years, which means they did not cut their dividend during the recent recession.
4. Dividends have grown at just over 4% per year over the last 5 years.
5. They have a balanced electric power generating capacity with plants that use gas, coal, nuclear, and a small amount of alternative power production.
6. Most importantly, they are well managed and serve a growing area.

Southern Company and many other high quality electric, gas, and telephone utilities offer good dividend yields, solid balance sheets, and modest growth prospects.  As investors come to grips with just how low interest rates are, we believe they will increasingly move to investments that offer higher yields.  We think the first place they will look is the utility sector and Southern is our top pick.

We own Southern Company and have no plans to sell it.

The Market is Wrong About United Technologies -- And A Lot of Other Companies

Our Dividend Valuation Model suggests that United Technologies (UTX) may be as much as 17% undervalued.  The chart at the left shows this undervalued condition in the price (red line) being much lower than the current value (blue bars).

Additionally, the models suggests that UTX is undervalued nearly 30% (blue checkered bar) when we input our dividend and interest rate estimates for next year.  The chart shows that one would have to go back to 1998 to find UTX as undervalued as it is today.

Undervaluation is not a term that means much to speculators and traders in today's market.  Indeed, recent data from the CBOE puts the Correlation Index at nearly 80.  This means that the average stock in the S&P 500 is now nearly 80% correlated to the movement of the Index itself, thus discounting almost all individual company fundamentals.  According to Bloomberg, this is the highest Correlation Index since 1987.

So what does it all mean?  Worries about european defaults, political stalemate in Washington DC, and slowing US and european economic growth have turned almost all big US stocks into commodities.  Most are acting about like their underlying index.  Not only are the daily price movements of United Technologies (UTX) and Boeing (BA) highly correlated, as you might expect from companies in the same sector, but also the price movements of UTX, General Mills (GIS), and Walmart (WMT) are also moving together.  As the old timers would say, we now have a stock market instead of a market of stocks. 

You will note that the last time the Correlation Index was this high was during 1987 when all stocks shot higher for the first six months of the year, and then all fell like a rock over the last six months of the year.  They all went in the same direction, regardless of their diverse underlying prospects.

I said in 1987 that the stock market had lost its mind, and I still believe it.  I believe history will show that today's congealed group think will be proved just as wrong.

Companies like United Technologies have huge free cash flows, lots of cash, and firm orders for future business.  It would not surprise me to see UTX trading near our model's target price of $95 per share in the next 12 months.  Indeed, I think the odds of UTX rising 30% over the next year are much higher than the odds of it falling 30%.  The main reason is they are a financially strong, innovative, and decisively managed company.  They can handle whatever is thrown at them.  There are untold companies that are bouncing up and down just like UTX that cannot make the same claim.

We own UTX. 

Barnyard Forecast: Conditions Are Still Positive for Higher Stock Prices

Periodically, we publish an update of our Barnyard Forecast (BF).  The BF is a back-of-the-envelope quick method of predicting how stocks will perform over the next 6-18 months.  If you do a search on our blogsite, you can see our previous updates.  On the whole, the BF has been reasonably good over the years at giving a sort of directional bias for the market.  As you remember the BF is taken from the acronym Economy+Inflation+Earnings+Interest Rates=Opportunity, in short EIEI=O.

For many years, the BF was calculated using a very simple scoring system that gave a thumbs up or down for the indicator as it related to its historical relationship with stock prices.  Over the last year we have made few updates that we believe improve the statistical integrity of the model.

Our last update on the BF was an audio blog by Randy Alsman on September 23, 2010.  In that blog, Randy went over each of the indicators and concluded that the model was forecasting rising stock prices over the next year.  Since that time, The Dow Jones 30, including dividends, is up almost 8.60%, even with the recent sell-off.

The following is the Barnyard Forecast's estimate of the next 6-18 months for the major stock market averages.

Economy: The first indicator is counter intuitive.  US GDP growth above 3.5% gives 0 points.  GDP growth of 2.0%-3.5% produces a neutral score of 1 point, and GDP growth below 2.0% is considered positive and produces the maximum score of 2 points.  The counter intuitive quality of this indicator is attempting to gauge the Fed's year-ahead bias.  Historically stock markets haven't done well when the Fed is hiking interest rates and vice versa.    With GDP currently running under 2.0% on a year over year basis, this indicator is positive for stocks and receives 2 points.

Inflation: The fulcrum level for inflation is Core CPI Inflation of 2.5%.  Above that level receives 0 points, near that level gets 1 point, and below that level receives the full 2 points.  Core CPI has stayed well below 2.5% for the entirety of the last year.  That performance is considered positive for stocks and receives the maximum of 2 points.

Earnings:  The fulcrum point on corporate earnings is year over year growth of 7%.  Seven per cent is the 80 year average of corporate earnings and has proved to be a good predictor of stock prices.  Again this indicator receives the full 2 points with S&P 500 earnings having risen nearly 12% over the last twelve months.

Interest Rates:  This is the indicator that we have sharpened up a bit.  We used to measure only the relative change in interest rates on a year over year basis: falling interest rates were positive and rising interest rates were negative.  Statistically, we found, however, that the yield spread between the 10-year US Treasury Bond and the 2-year US Treasury Note had better predictive qualities than the original method.  In this case, the fulcrum point is 0.  This means that if 10-year interest rates are higher than 2-year interest rates, the model receives the full 2 points.  If 2-year Treasury Notes are yielding more than 10-year T-bonds, the model would receive 0 points.  Currently, 10-year T-bonds yield 2.0% more than 2-year notes and receive the maximum 2 points.

Opportunity: With all of the indicators in the Barnyard Forecast receiving the maximum of 2 points, the model's total score is 8 points.  That is a score that I don't believe I have ever seen in the last 15 years and would indicate that stocks should perform well over the next 6-18 months.  Indeed, with a score that high, one could say that stocks should perform "better than well."  However, let me offer just a few words of caution.  This is not an econometric model.  additionally, it is really not a pure forecast of what stocks will do over the next year.  It is simply a measure of how the stock market has acted in the past when the EIEI=O indicators scored as they do today.  I will add, however, that the model's buy and sell signals have been correct about 77% of the time.  The only problem is that it has spent up to a year and a half giving the wrong signal, so it is not an indicator that we follow blindly.  

It is saying, however, that in the past when the the aforementioned indicators have scored as they do today, that there has been a good probability that stocks have gone higher. 

Blessings,

Greg