<FOOLISH WORKSHOP>

Utility Futility?

by Ethan Haskel ([email protected])

Baltimore, MD (Feb. 24, 1999) -- Over the years I've received quite a few queries about how Beating the S&P (BSP) handles utility stocks. Most utility companies pay large dividends and thus seem ideal for a strategy that embraces high yield investing. But then why do the ground rules for choosing BSP stocks specifically exclude these stocks?

The most direct answer is that the BSP 30 stock list was created to form an "Un-Dow" -- or an alternative to the more popular Dow Dividend strategies. The Dow Jones Industrial Average explicitly excludes utility and transportation stocks. Each of these sectors has its own index, namely the Dow Jones Utility Average and the Dow Jones Transportation Average.

The Dow Jones Utility Average was created in 1929 and currently includes 15 stocks rather than the 30 that comprise the Industrial Average. Like the Dow industrials, the Utility Index seems to favor the largest of the American gas and electric companies. Telephone companies such as the Baby Bells are not included, although AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %> was originally a charter member of the index. Similar to the Dow industrials, the Utility Index is a price-weighted index. The stock's price, rather than its market capitalization, determines its influence on the index.

How might the exclusion of utility stocks affect the performance of Beating the S&P? Historically, utility stocks as a group have woefully underperformed the general market. For instance, from 1977 to the end of 1998, the Dow Jones Utility Index has had a compounded total return of about 188%. That's small potatoes compared to that of the 30 Dow Jones Industrial stocks, which have returned about 814% over the same time period. Thus it is doubtful that inclusion of more utility stocks would help the returns of a BSP portfolio.

From a practical standpoint, it seems unlikely that utilities would show up frequently, if ever, in any BSP portfolio. The main reason is that utility companies are regional and thus almost by definition have a size ceiling. Since BSP considers only the very largest of American companies, it would be very difficult (although not impossible) for regional utilities to qualify for the list. For instance, the most current Business Week listing for the Top Companies of the S&P 500, lists Duke Energy <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DUK)") else Response.Write("(NYSE: DUK)") end if %> as the largest utility stock with a market capitalization of 20.0 billion dollars. The smallest stock in the BSP 30, with respect to market capitalization, was Campbell Soup <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPB)") else Response.Write("(NYSE: CPB)") end if %> with a capitalization of 26.4 billion dollars.

What about those Baby Bells, the eight companies formed after the government-mandated breakup of AT&T in 1984? For BSP purposes, they've traditionally been included with utility stocks and dropped from consideration. Part of the reason for this decision is historical. In the initial 1986 Business Week listing of the largest American stocks, these companies were listed as "utilities, telephone." Over the past few years, these companies have evolved into "telecommunications" conglomerates, far removed from their staid forefathers who basically collected fees for local phone services.

I've decided to continue to discard these companies from the BSP for a number of reasons. Unlike the utility companies included as part of the Dow Jones Utilities Index, many of these companies are quite large and most all pay out relatively large dividends. If included in a BSP portfolio, they would tend to dominate the listings, significantly limiting diversification. For instance, if the Baby Bells were included in this year's Official 1999 Portfolio, two of the five stocks would be Bell Atlantic <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BEL)") else Response.Write("(NYSE: BEL)") end if %> and SBC Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SBC)") else Response.Write("(NYSE: SBC)") end if %>.

As a screening purist who believes in strict rules for backtesting, I wouldn't have an objective measure as to when these companies "crossed over" and became true telecommunications companies. When BSP was initially created and backtested, I discarded these companies and noted they were categorized by Standard & Poor's as telephone companies. BSP does make room for telecommunications companies (as defined by S&P); Lucent <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LU)") else Response.Write("(NYSE: LU)") end if %> and Sprint <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FON)") else Response.Write("(NYSE: FON)") end if %> are two examples. In my mind, an objective time to include the Baby Bells in BSP would be when (or if) S&P reclassifies them as telecommunications companies.

The moral of this story? Use those Dow utility companies to power your home and business, but not your portfolio!

*****
Beating the S&Pyear-to-date returns (as of 02-23-99):

Schlumberger <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SLB)") else Response.Write("(NYSE: SLB)") end if %> +4.2%
Kimberly-Clark <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KMB)") else Response.Write("(NYSE: KMB)") end if %> -11.5%
Campbell Soup <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPB)") else Response.Write("(NYSE: CPB)") end if %> -25.1%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> +1.7%
BankAmerica <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +11.3%
Beating the S&P -3.9%
S&P 500 +3.7%

Compound Annual Growth Rate from 1-2-87:
Beating the S&P +20.1%
S&P 500 +17.9%

$10,000 invested on 1-2-87 now equals:
Beating the S&P $91,700
S&P 500 $73,400

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