Last week, I posted an article on why the recent rally did not look anything like a bull market titled “An amazing market rally. What’s next?“o, it seems like I was bullish for all of two weeks. Yet, the truth is I was never bullish on the market as a whole. But, I do think there are many stocks trading below fair value due to the fall in stock prices.

I mentioned energy as a sector to watch. In that, I would actually include utilities – a related industry. Most people see utilities as boring — the beta on a typical utility stock is far less than one. Yet, these companies pay fairly high dividends and have relatively low price-earnings ratios. To my mind, that looks like a very good defensive play.

Apparently, Warren Buffet thinks so as well because he has been on a shopping spree buying up utilities. You’ll remember that there has been a push toward deregulation worldwide, which has hit the capital intensive utilities business particularly hard. But prices have dropped too low, meaning some companies are well worth buying. The hard part is figuring out which ones.

Jim Jubak at MSN Money has a good post on this issue today. There, he says:

First, let me try to reconstruct some of the logic behind Buffett’s liking for the sector:

  • Because utilities need so much capital, they’re a good match with an investor who has billions and billions in cash. Berkshire Hathaway finished 2007 with $44.3 billion in cash and short-term investments. That year the company generated $12.5 billion in operating cash flow. At the start of 2008, Constellation Energy had planned for a capital budget of $2.4 billion.
  • Because utilities need so much capital, their stocks have been hit hard by the financial crisis of 2007-08. Constellation sold to Buffett for such a bargain price because chaos in the markets made it impossible for the company to raise the money it needed for everything from its capital spending to its day-to-day operations. (It didn’t help, of course, that Constellation had jumped whole hog into trading energy. That gave the company even bigger exposure to the problems at Lehman Bros. (LEHMQ, news, msgs) and other Wall Street financial companies.) MidAmerican Energy was able to strike such a great deal for itself because it promised to inject $1 billion in capital immediately into Constellation.
  • Because utilities, even financially stressed ones such as Constellation, generate so much cash, Buffett can buy these shares without worrying too much about when the bear market will end. In many of his recent deals, Buffett has looked to combine the upside potential of stock appreciation with the insurance of a high current dividend. In his investment in Goldman Sachs Group (GS, news, msgs), for example, Buffett got warrants to buy stock at a fixed price in the future, so that if the stock goes up, he profits. And he got preferred stock paying a 10% dividend, so he collects even while he waits for the stock to go up. (By the way, Buffett’s preferred stock pays twice the 5% yield taxpayers got on the preferred stock we received when we put money into Goldman Sachs.) In 2008, while Buffett waits for Constellation to recover in the stock market, the company will generate $1.4 billion in cash from operations, according to projections by Deutsche Bank.
  • And finally, Buffett likes the rising future returns in the utility sector. In the next 20 years, the utility industry will need to invest about $1 trillion in new power generation, including nuclear, clean coal, natural gas, wind and solar power, in new transmission lines and grid enhancements, in new forms of energy storage and in environmental solutions to problems such as global warming. Companies that can raise the cash will have almost unlimited places to invest it — at rates of return that are guaranteed by state utility regulators. So the industry is looking at a scenario where it can put all the cash it generates — and all it can raise — to work at a rate of return guaranteed to exceed the cost of capital. Each year, utilities will be able to reinvest their cash flow in new plants and equipment that will, in turn, generate a guaranteed rate of return. And so on and so on, compounding over the next decade or two.

My reconstructed version of Buffett’s scenario is pretty much what led me to invest in Edison International in July. So why did that pick turn into such a disaster? Because there are a few minor differences between you and me and Buffett.

First, Buffett can buy a strapped utility such as Constellation and in one fell swoop make sure that the company can fund its capital projects. If you and I buy a few hundred shares, the company still has to go out to the capital markets to raise the money it needs.

And if it can’t — and plenty of utilities can’t right now — then it has to cut back on plans to invest. And power plants, transmission lines and solar modules that aren’t built don’t generate revenue. If you own shares of a utility now that can’t raise money now and has cut capital spending now, the fact that you, like Buffett, are right about the long-term positive trends in this industry is irrelevant. The stock tumbles.

Second, Buffett gets deals when he buys shares of Goldman Sachs or buys control of Constellation that none of us can get. If I were getting a 10% yield on my shares, I’d be a lot less worried about how long it was going to take for the bear market to end and stocks to start going up again. If I gained control of a company when I bought into it, I’d fret less about the possibility that in the near term management would do something — like selling at a bargain-basement price — that worked against my interests in the long term.

I can’t think of anything to give me control over as many billions as Buffett can direct — at least not in the short run — but I do think there’s a strategy that will compensate for these differences between you and me and Buffett. That strategy has three parts.

1. Pick and be patient

You want to find utilities that, before the credit crunch, had big plans to expand power production using a combination of sources — wind, solar and nuclear — and had existing investments in those areas to build upon, and that were making significant investments in upgrading the transmission grid and the system for delivering power to customers. Right now those utilities are also announcing cuts to their capital budgets.

You’d like to buy these utilities at a point as close as possible to the moment when they’ve made their last capital spending cuts. With a potentially long and deep recession ahead, we’r
e likely to see more capital spending cuts in 2009. Wait. The two utilities I like most for the long run are FPL Group (FPL, news, msgs), with its mixture of conventional nuclear, and wind power, and the one I sold in October, Edison International, because this is a utility that really understands how important upgrading the grid is. Right now, though, you’re at least six to nine months early on these. I’m adding them to my watch list with this column (see the list on the left-hand side of this page).

I recommend reading Jubak’s article in full. However, I would point out that Jubak recommends proceeding with caution given that we do not have the funding advantages of Warren Buffett and capital spending has yet to hit a bottom in the industry. And I agree that one needs to understand the finer points of the industry before jumping in wholesale. After all, we are still in a bear market.

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