The importance of deregulation in shaping the industry is paramount. The days of peace and stability in the utility sector are history, and companies are going to be forced to sink or swim in the competitive waters. A handful of companies are likely to do well for their shareholders, but we encourage investors to be extremely picky when it comes to buying utilities.
Investor's Checklist: Utilities
• Utilities are no longer the safe havens they once were. Treat them with an
appropriate amount of caution.
• The competitive structure utilities must operate under is largely set at the
state level. Some states have gone far along the deregulation path; others
have utilities that are fully regulated. Keeping track of changing regula
tions in different states can be maddening, but it is necessary to under
stand the sector.
• Regulated utilities tend to have wide economic moats because they oper
ate as monopolies, but it's important to keep in mind regulation does not
allow these firms to parlay this advantage into excess returns. In addition,
regulation can (and often does) change.
• Another risk all utilities face—deregulated or not—is environmental risk.
Most power plants generate pollution of some kind. Should environmen
tal regulations tighten, costs could go up.
• Utilities have a great deal of leverage, both operational and financial. This
is not so important for regulated firms, but it exponentially raises risk for
companies facing increasing competition.
• If you buy a utility for its dividend, make sure the firm has the financial
wherewithal to keep paying it.
• Utilities that operate in stable regulatory environments with relatively
strong balance sheets while staying focused on their core businesses are
the best bets in the sector.
