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Utility stocks trade at a discount to the stock market as a whole. And at a bigger discount than usual. The forward price-to-earnings ratio based on projected earnings for the next twelve months is just 80% of the forward P/E ratio for the market as a whole. The long-run average is 85%.

Yet I don’t think the sector as a whole is a roaring buy. In fact, I think the average utility stock is over-priced.

So how can the sector be cheaper than the long-term average and over-priced at the same time? Because uncertainty and risk for the sector as a whole has soared. To find a utility stock to buy—and I’ll give you three suggestions (including one buy) at the end of this post—I think you need to find shares of those few utilities that have navigated a clear course around those risks or that have lucked into a way to avoid the worst risks.

What are the risks? You don’t need to take off your shoes to count ‘em. Two hands will do. (Or one if you’re Anne Boleyn.)

  • Stronger than I expect (something more like the Federal Reserve’s projection of 3% to 3.5% rather than my estimate of 2%) economic growth in 2010 will hit utility stock prices hard.
  • Fuel prices—especially currently low coal and natural gas prices—will climb faster than utility regulators will act to allow utilities to add them to the rate base.
  • Higher interest rates from the Fed will cut the prices of dividend paying stocks.
  • Higher interest rates in the bond market will make raising money for capital investment more expensive.
  • New Environmental Protection Agency rules on carbon dioxide emissions will require massive new capital spending. (For a summary of the EPA’s recent regulatory moves on carbon dioxide se my post .)
  • Energy efficiency incentives will keep demand lower than expected even in an economic recovery.

Pick a utility—any utility—and you can see these issues at work.

At American Electric Power (AEP), for example, the slow economy hurt the company’s sales in a core service area that serves 5 million retail customers in 11 states. Two of those states Ohio (39% of utility revenue) and Indiana (16%) have been particularly hard hit by the recession. American Electric Power has built a good business in using its central location, to supply power to other utilities. These out of system sales also took a hit in the recession. Rules that restrict the company’s emissions of CO2 could turn another one of American Electric Power’s competitive advantages—its proximity to the coal fields of Appalachia—into a liability. (The company gets 86% of its power from burning coal.)

But this being the utility sector, where the rules of what we call free-market economics often get turned on their head, not all these risks work out quite the way you’d expect. And to understand their impact you need to dig deeper into what seem to be obvious risks.

So, for example, the need to invest capital to control carbon emissions isn’t nearly as dire as it seems from my list. Capital investments get factored into the rate base by utility regulators and the return that a utility such as American Electric Power gets on these investments in its regulated utility business can help fill coffers that ring a little empty because of slower economic growth.

The company’s central location, while perhaps not as much of an advantage when it comes to cutting the cost of coal, has given American Electric Power a pipeline of long distance transmission projects since the company is positioned as a key link in any attempt to connect the country’s three now relatively unconnected regional electric grids. Interstate transmission lines are regulated by the Federal Energy Regulatory Commission (FERC), which has approved relatively higher returns on investment in an effort to fix decades of underinvestment in the national grid. The relatively lower capital requirements of transmission lines—in comparison to power plants—makes this an especially attractive investment in a time when raising capital is difficult and likely to be increasingly expensive.

This isn’t to say that utilities aren’t strikingly riskier and in strikingly different ways than they used to be. In some ways, for example, American Electric Power now resembles a technology company and investors in these utility shares are taking on technology risk of a kind that has been basically unknown in the utility business since these companies stopped building nuclear power plants in the 1980s.

American Electric Power, because of its reliance on coal to generate the bulk of its electricity, is one of the sector’s leaders in efforts to develop clean-coal technologies. The company launched an effort to build two Integrated Gasification Combined Cycle power plants in 2004. The plants, in West Virginia and Ohio, are designed to turn coal into a gas that can then be cleaned before burning to remove many pollutants.

That doesn’t really tackle the carbon dioxide emissions from burning coal so the company has become a major proponent of efforts to capture carbon dioxide from coal-fired power plants and then inject it deep underground. The company received $334 million from the U.S. Department of Energy on December 4 to develop a commercial –scale plant using this technology at its Mountaineer coal-fired plant in West Virginia.

I think American Electric Power gives investors a reasonable template for figuring out what to look for in a utility investment today. (Which is why I’m adding it to the Jubak’s Dividend Income Portfolio today. I’ll post a full buy rationale later today.)

And I think that template fits two other utilities that I’d add to a watch list or purchase for an income portfolio today depending on your current need for safety and income, and your current asset allocation.

One is Public Service Energy Group (PEG). Like American Electric Power, Public Service Energy offers investors a regulated utility in New Jersey with a key geographical position in the power grid. (In this case a part of the PJM Interconnect that coordinates power sales and distribution in 13 Eastern states.) As with American Electric Power, Public Service Energy has moved into the transmission business with a list of proposed projects now in front of regulators. And while the company doesn’t have the potential investment gains from clean coal and carbon capture technologies (and risk), it has become a key partner with the state of New Jersey in green energy technologies.

A second is ITC Holdings (ITC), which is the only publicly-traded transmission pure play that I know of in the U.S. utilities sector. The company started in 2003 with the acquisition of the transmission subsidiary of Detroit Edison.  It now owns two other transmission companies that it acquired in 2006 and 2007.

This independent transmission company is regulated by FERC, which has historically set rates so that investments in the transmission grid earn a return on equity of 12% to 14%, according to Deutsche Bank, versus the roughly 10% return set by state utility regulators. With improvements to the grid a high priority among utility companies and increasingly in Washington, Deutsche Bank projects that the company can grow earnings by 15% annually over the next five years. That’s extraordinary growth for a utility stock.  ITC Holdings trades at 18 times projected earnings for 2009. (It pays a relatively low yield for a utility stock of just 2.7 %.)

I’ll have more to say about ITC Holdings when I write about the “dumb” grid next week.

(Full disclosure: I own one share of American Electric Power that I acquired in 1980 so I could go to the company’s shareholder meetings and that I’ve never sold.)