The Arsenal of the Income Investor

I have been thinking about some of the recent ruckus in the oil industry, and the perpetual trend of poor timing regarding oil stocks–when the earnings are exploding and the valuations are high, people run towards these firms. And when the dividend cuts start coming, the retreat escalates. I understand why it happens–few want to see collapsing earnings, dividends, and stock prices of the companies they own, but the performance of anything oil-related is tied to the cyclical performance of oil.

The reason why you only pay 10x earnings for Exxon when earnings are growing fast (rather than something like the 20x earnings you regularly see with Coca-Cola) is that these firms often carry plummeting earnings far off in the distance. If you bought Exxon in 2003, the reason why you only pay 10x earnings is because you know that years like 2008, 2009, 2014, and 2015 will come along when earnings deteriorate rapidly. It takes extraordinary skill to predict when it will happen, and thankfully, a long-term investor need not worry about this if he is sufficiently diversified, reinvesting, and starting at a decent (or better valuation). But the point is that, even in good times, the valuation should be tempered because bad times for commodities lurk ahead somewhere in the distance.

Of course, the opposite of this point is true as well. Just as people need to temper their enthusiasm during oil booms, they need to become cautiously optimistic during the bad times (and appears downright enthusiastic as conditions worsen if you are talking about the original Seven Sisters that thoroughly dominate the global energy markets). The poet Horace reportedly said over 2,000 years ago that we should “avoid undue elation in prosperity, or undue depression in adversity.” Not only is that a good life motto, but it is a great thought to keep in mind if you pursue a lifetime of oil stock investing. Just as oil stocks deserve to have their valuation tempered during good times for the bad days ahead, the same stocks deserve to have their valuation more elevated during poor times because there will be higher commodity prices ahead.

The oil majors, in particular, keep increasing their production by a steady clip each generation, but it comes in the form of a man walking up the stairs with a yo-yo because people dwell on the 50% changes in prices of the underlying commodities rather than notice the productive power of the enterprise growing through the generations.

All of this explains why I believe that oil majors are great investments in response to distress, which may include dividend cuts. But it only captures part of the strategy. After all, you need available cash coming in through passive holdings to take advantage of assets that you acquire on the basis of potential rather than current earnings reality.

This is why I believe that utility stocks are a vastly underrated segment of the income investing universe, as they reliably provide incoming cash that can be used to fund a lifestyle or take advantage of attractive opportunities. It’s been a while since I studied it, but I seem to recall York Water (?) paying out dividends dating back to before the Civil War. It captures the nearly timeless human elements that: (1) people need water and electricity, and (2) paying the utility bill is one of the very first things someone does with their paycheck.

This leads to remarkably stable earnings and consistent dividends. There is a place for this in every man’s portfolio, as you need strong defensive income to provide you with the ballast to go on the offensive in search of opportunities.

Take something like MGE Energy, the ticker symbol MGEE. It was formerly known as Madison Gas & Electric. It has a pretty simple business model–it provides gas and electricity to residents, businesses, and government offices in Dane County and seven other counties in near the Wisconsin capital. It has 292,000 total customers that pay $575 million in annual bills, for an average monthly payment of $164 (the number is dragged up by the industrial warehouses and large commercial centers that are included).

The earnings growth is never high–certainly never anything to brag about–but the consistency and reliability of profits is always there. Even between 2007 and 2009, the company barely saw earnings dip as utility rates were frozen and some people lost their jobs and went into default on their obligation. The end result? $1.51 in 2007 earnings turned into $1.47 in 2009 earnings. The annual dividend went up from $0.94 to $0.97. You don’t buy it for growth; you buy it for the certainty that if you reinvest there will be something left, and the fact that the income streams keep coming in when other sources of income dry up.

I also want to challenge the conventional wisdom that utility stocks don’t outperform the market. They often have earnings per share growth in the 6% neighborhood, and that is why you don’t rely on market outperformance from utilities, but the odds might be better than you think. A curious thing happens when profits keep getting generated as utility payments roll in month after month, and shareholders get a share of that every 90 days.

It has the following long-term performance characteristics: 11.3% annual returns since 1990, 10.5% annual returns since 1995, 12.0% annual returns since 2000, 9.5% annual returns since 2005, and 14.5% annual returns since 2010. Even now, it only trades at 19.5x earnings (the highest end of fair value).

If you elect to reinvest, the income can really turn into something substantial if you sit back and let the shares compound upon themselves over and over again. If you invested $10,000 into Madison Gas & Electric back in 1990, and reinvested every single dividend, you would have 3,809 shares today (compared to a split-adjusted 338 shares at the time of your initial investment). You add over 100 new shares every year due to dividend reinvestment, and this is actually a point in Madison Gas & Electric’s recent history when dividend investment is least lucrative. In the late 1990s, the stock got surprisingly undervalued as the investing world became obsessed with emerging tech, and the stock would yield over 7% (really kickstarting the share accumulation process).

Although the P/E ratio of MGEE is a bit higher than usual right now, the company does have an advantage it doesn’t usually have: retained earnings. In the early 2000s, it was paying out almost 90% of its earnings as dividends. It paid $0.92 in 2005 dividends while earning $1.05 for an 88% dividend payout ratio.

Because the dividend barely goes up each year–the current dividend of $1.18 isn’t much higher than the $0.92 payout in 2005–the company has been able to build upon its financial strength while earnings have climbed to $2.15. Now, it is only paying out 54.8% of profits to shareholders as dividends.

If you look at a chart, these types of utility never seem to do much. The stock traded around the $20s every year between 1995 and 2011. Current earnings of $2.15 are barely double the earnings of $0.99 in 1999. Looking at the company’s growth, and share price movement, wouldn’t catch your attention.

But it is the kind of thing that, once you tuck it into your portfolio, you never let it go. Why? Because it keeps sending you cash. And the next year, the amount goes up a little bit. Only enough to keep pace with inflation or so, but the certainty of the increase is so high that it ought to make you happy to have a few ‘ol reliables.

Tying it all together, I’d conclude this: Dividend cuts are not proof that an enterprise is in trouble. Oftentimes, especially when the overall profits are tied to commodities that are notorious for fluctuating, the dividend cut perversely signals that the stock has gotten so cheap it is a “value buy.” But a portfolio needs balance–reliability–from somewhere that can provide that income stream to zap when the moment arrives. Consumer staples and healthcare stocks are good at this, and tobacco stocks have been good at this. Even Exxon and Chevron have been good at this. But there is something about utilities–the earnings rarely fluctuate, and the dividends keep coming. You build up a dozen or so of them early enough in life, and they will serve as a great foundation to do interesting things when those lucrative but temporarily illiquid opportunities arrive.