Utilities for tax-advantaged income

Ask any retired person if his or her expenses are growing as slowly as the government's stated rate of inflation, and you are likely to elicit a laugh.

Marvin Appel, PhD, and Brian Hufford, CPA

Ask any retired person if his or her expenses are growing as slowly as the government's stated rate of inflation, and you are likely to elicit a laugh. Medical expenses and college tuition — items we all pay for sooner or later — have been growing faster than inflation. So how can you plan your investment strategy now toward financial security later?

Bonds are not a long-term solution right now, with interest rates so low and with so many forces that could push them higher in the next year or two. (Problems that might confront the bond market include our large trade deficit and weak dollar, large government deficits, rapidly rising commodity and energy prices, etc.)

As we discussed in our November 2003 column, the government has provided a potential solution in the form of a tax cut on dividend income. This is especially valuable to those of you looking to build savings in addition to your allowed contributions to tax-deferred retirement plans. We also recommended a number of diversified, exchange-traded fund investments with above-average dividend yields. This month, we will focus on another traditional source of generous dividends — utility stocks.

Why stock dividends are important

Dividend-paying stocks, including utilities, offer the potential of a rising income over the long term. Bonds (with few exceptions) pay fixed rates of income, so your standard of living would be vulnerable to long-term price inflation. The advantage of utilities is that as inflation pushes up the price of the electricity, the utilities' ability to pay dividends also will likely increase.

Moreover, the new tax law makes the long-term ownership of dividend-paying stocks a favored strategy. To the extent that the share prices grow, taxes are deferred until you sell. The income from dividends available for you to spend is taxed at relatively low rates.

Utility stocks appear potentially attractive for a number of reasons. Dividend yield — the stocks in the Dow Jones Utility Index now pay 3.6 percent per year. This is low by the historical standards of utility stocks, but quite high compared to dividend payouts elsewhere in the market. (For example, the Dow Jones Industrial Average currently pays 2 percent.)

Supply/demand balance is relatively favorable to producers of electricity — from 1982 to 1999, the maximum generating capacity fell from 130 percent of peak demand to below 110 percent of peak demand. Since then, relative generating capacity is 112 percent of peak demand, which is lower than at any time before 1997.

Energy consumption per person in the United States has remained fairly constant during the past 20 years. The implication is that the utility sector is likely to grow at least as fast as the population. Electric utilities have not been hurt by rising energy prices; they have succeeded in passing along higher costs to consumers.

Caveats

The potential downside to utility stocks has been the trend toward greater energy efficiency. Energy consumption per dollar of economic production (GDP) has been falling by 1.9 percent per year since 1970 (adjusted for inflation), so the utility sector is growing slower than the overall economy.

Though utilities are on solid ground, this sector has undergone severe bear markets in the past 75 years, and should be considered at least as risky as the broader stock market. The best way for long-term investors to use utility stocks is to accumulate them for 20 years or more. Investors with asset-protection techniques to use during market declines should consider applying those techniques to their utility-stock holdings as well.

Recommendations

The above-average dividend yield could compensate for the below-average potential growth rate in the industry. Trends toward tighter energy supplies will probably aid the sector, as they have for the past 20 years. An excellent vehicle is the Utilities Holdr, ticker UTH. This exchange-traded fund has a dividend yield of 3.9 percent and a very low expense ratio of 0.1 percent per year. Its price action has tracked that of the Dow Jones Utility Average. This type of stock is best purchased for long-term holding in a discount brokerage account, and must be purchased only in "round lots" of 100 shares.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is co-author of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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