At this point in the market cycle, conservative investors normally think about moving money into stable sectors such as utilities and telecommunications. But valuations in these sectors have climbed, and the corresponding market action of stocks in these industries has become unpromising.

This observation is similar for both Canadian and U.S. utility and telecom stocks.

In Canada, the S&P/TSX utilities and telecommunication services sector subindices are throwing off negative signals and their uptrends appear uncertain. The TSX utilities index closed March at 1,643, down from its record high of 1,820 at yearend 2005, and the telecom subindex closed out March at 719, down from its five-year high of 790 last September.

Both sectors have made big moves over the past four years, rising 41%-42%. Nevertheless, relative to the S&P/TSX composite index — which gained 57% over the same period — the utilities subindex is at its lowest point since 2001, and the telecom subindex at its lowest since 1998.

Four years ago, the composite index and the telecom sector had no earnings, while the resources sector was at the bottom of its cycle. Utility earnings are up a mere 4% since 2002.

Both the composite index and the utility sector subindex now trade at 20 times earnings, with the telecom subindex at 16 times. Three years ago — to start at a point at which composite index earnings were again being reported — the composite index traded at a price/earnings ratio of 29, with utilities at 13 and the telecom subindex at 14.

Dividend yields and the expectation of steady payments into the future are, of course, at the heart of utility and telecom stocks’ appeal. The utility subindex now offers a 4.7% yield, up from 3.9% four years ago, and the telecom subindex yields 3.2%, down from 4.2%.

The dividend growth record is more encouraging. Fortis Inc., the Atco Ltd.-Canadian Utilities Ltd., pair and Manitoba Telecom Services Inc. continue to raise their payments almost every year. Emera Inc. has raised its payment in most recent years, and Telus Corp. has increased its payment in the past two years. BCE Inc. raised its payment last year for the first time in five years.

Profitability trends are mixed and profitability rates vary greatly. Recent three-year average return on equity and after-tax return on invested capital increased for Fortis, Aliant Inc., MTS Inc., Rogers Communications Inc. and Telus over the average for the preceding three years. Both returns dropped for Transalta Corp.

ROE gained and return on invested capital dropped for BCE and Emera in comparing the three-year averages. Average ROE dropped but return on invested capital improved for Atco and Canadian Utilities.

Takeovers have had an impact, as the number of utility and telecom stocks available for investors in Canada has been trimmed while the once-normal stability of these industries has been upset by new forms of competition and deregulation. Events of the past decade have lowered the overall investment quality of these sectors.

In the U.S., deregulation has overwhelmed the electric utility industry. Forays into trading energy futures were a huge mistake. Now the industry can muster only a few companies worthy of even an “average” quality rating from Standard & Poor’s Corp.

Mergers, takeovers and the collapse of long-distance companies have also squeezed the number of U.S. telecom stocks. When the new AT&T (formerly SBC Communications Inc.) takes over BellSouth Corp., there will be one less giant.

Historical comparisons say utility and telecom shares are highly valued. A fundamental measure of this is a stock’s price relative to the book value of its shareholders’ equity. Of the 11 stocks in the S&P/TSX capped utility and telecom subindices, five are trading at their highest price/book value ratios in five years. Several others are just a shade below their highs.

No longer cheap

Currently, they trade at an average of 2.1 times book value, compared to 1.8 times in April 2003. These are not cheap levels: utility and telecom stocks traded below book value in 1982, when the market was truly bargain priced.

U.S. utility and telecom stocks have followed a path similar to Canadian stocks. U.S. utilities, though, have had a big bull market, rising 63% in the past three years from a deeply oversold level. The pace slowed last year, when the S&P utility sector gained 4% and the telecom sector gained 11%.

@page_break@Operating earnings of the S&P utility sector are forecast to rise 16% this year, after a 13% rise last year. For U.S. telecom stocks, the expected operating earnings rise is 13%, following a 6% gain last year.

Canadian investors now take more interest in Duke Energy Corp., one of the U.S. giants, because of its Canadian holdings acquired four years ago through Westcoast Energy Inc. Canadian assets are 23% of Duke’s total and revenue from Canada is now 20% of the total.

Duke shares trade at 1.6 times book value, down from 2.9 times five years ago. After seven years without a change, Duke’s dividend increased 13% last year to the current US$1.24 rate. The dividend, currently yielding 4.4%, is of course fully taxed in Canadian hands, with allowance for withholding taxes paid.

As in so many sectors of the Canadian market, income trusts have become a factor in utilities and telecommunications. But approval is less than universal. Skeptics point to the derivative nature of trust units.

Bell Nordiq Income Trust’s annual report gives an example of this, saying: “The units share attributes similar to both equity securities and debt instruments. The units do not represent direct investments in the businesses of Télébec and NorthernTel and therefore should not be viewed as Télébec units or NorthernTel units. Our unitholders do not have statutory rights normally associated with the ownership of shares of a corporation, such as the right to bring ‘oppression’ or ‘derivative’ actions.”

Another problem is determination of earnings. Again, to quote Bell Nordiq’s report: “Available distributable cash is not defined under Canadian generally accepted accounting principles and there is no standardized measure for distributable cash. As a result, the way we define available distributable cash may be different from the way other limited partnerships or income funds define it.”

For these reasons, income trusts lack general approval, and garner mistrust from some investors and money managers. IE