Situation: Investors tend to shy away from companies that have limited pricing power, namely companies in government-regulated industries: electric utilities, railroads, 5G wireless communications, systemically important financial institutions or SIFIs, and defense contractors. Those underpin the national economy and national security. To ensure safe and effective operations, regulators may allow companies to function as quasi-monopolies. For example, railroads and electric utilities face little competition in their dedicated catchment areas.
State and national government agencies perform the regulatory functions, making sure that consumers are billed enough to allow timely and effective maintenance of the underlying infrastructure. Profits at these vital companies are capped. In most states, the Public Utility Commission historically set annual ROIC (Returns on Invested Capital) at ~10%, and the billing rate for customers is set high enough to ensure that ROIC. Investors need to think of the shares they hold in an A-rated regulated public utility as akin to an investment-grade bond that pays 10% interest.
Mission: Using our Standard Spreadsheet, analyze all 22 companies in the Russell Top 200 Index (IWL) that are in these 5 government-regulated industries. Use Berkshire Hathaway (BRK-B) for reference because that company owns both the largest US utility company (Berkshire Hathaway Energy) and largest US railroad (BNSF Railway), and a major defense contractor (Precision CastParts); it also has billions of dollars worth of shares in both the largest 5G wireless company (VZ) and the largest SIFI (BAC).
Execution: see 22 Companies in the Table.
Analysis: Warren Buffett’s favorite metric is addressed in Column R of the Table: Return on Net Tangible Capital Employed. He thinks anything over 20% is a good number. Only one company (LMT) meets that standard. His second point -- that the company is to be “run by able and honest managers” -- is addressed in Morningstar reports (see Column AM) and is negatively impacted by the degree to which managers and directors choose to capitalize their company with long-term bonds rather than common stock (see Column V). Two companies (LMT, D) have a BUY rating from Morningstar, and 3 companies have “gearing” (the ratio of Long-Term Debt to Equity) of less than 1.0 (NSC, RTX, GD). He has also stated that high Free Cash Flow Yield (Column I) reflects good management because Retained Earnings allow the company to expand (or pay down debt) at zero cost. Twelve companies (CSX, TMUS, UNP, NSC, VZ, JPM, CMCSA, LMT, NOC, BAC, GD, C) have Retained Earnings (meaning that Free Cash Flow more than covers dividend payments). Warren’s third point -- that the stock be available “at a sensible price” -- is addressed by the 1-year and 3-5 year Forward PEG ratios (see Columns M and N): Five companies have estimated PEG ratios at both time points of 2.0 or less (CSX, TMUS, NSC, CMCSA, RTX).
I like to invest in "The 2 and 8 Club." That is, A-rated companies that reliably pay an above-market dividend and have grown that dividend at least 8%/yr for the past 5 years (see Column J). Six companies meet that standard (NEE, UNP, JPM, CMCSA, LMT, GD).
Bottom Line: Uncertainty about future downside risks are a chief concern of investors. Given the lack of pricing power that CEOs of these companies face, as well as having profits capped by government officials, investors can be forgiven for questioning the future prospects of these companies. But remember: government regulation of your Return on Investment comes with government insurance of your Return on Investment.
Risk Rating: 7 (where 10-yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into NEE, UNP, JPM, RTX and T, and also own shares of TMUS, BA, LMT, GD and C.
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