What’s the Best Stock You Don’t Own?

When you live off the income generated by your investments, a steady payout is paramount.

That’s why we’ve built a high degree of redundancy into our analysis of the threats to a company’s dividend. Like a critical piece of machinery, our dividends need to be as reliable as possible.

Consequently, we employ a double-layered system to gauge the safety and sustainability of a company’s payout.

Most subscribers are likely familiar with our longstanding Safety Rating System, which aggregates eight fundamental criteria into a single statistic that gives us a quick snapshot of dividend safety.

But no system is infallible. So we’ve layered an Early-Warning System on top of our Safety Rating System as an additional measure of dividend sustainability.

Since both systems incorporate a number of key financial data into a single metric, they can also be useful when evaluating new ideas for investment.

In fact, in its initial incarnation at another publication, the Early-Warning System was used as a tool to assess the quality of an energy utility’s management team.

In his former life, our senior editor Richard Stavros helmed Public Utilities Fortnightly, the premier trade journal of the utilities industry–or as Richard describes it, the intellectual clearinghouse of the utilities sector elite.

During his tenure, Richard along with another colleague developed a proprietary tweak of a classic financial model that was originally created by an executive at DuPont in the 1920s.

They then applied that model, which examines the factors driving a firm’s return on equity, to the utilities sector to compile an annual list of the 40 best-managed utilities in the U.S.–The Fortnightly 40.

When Richard joined Utility Forecaster, he helped adapt his proprietary model for use as our Early-Warning System.

Meanwhile, Richard’s old publication kept on trucking with his original model and is now in its 10th year of using it to produce the Fortnightly 40.

Although the Fortnightly 40 is not necessarily intended to guide that magazine’s readers toward great investments, that doesn’t mean we can’t use it that way.

After all, the aim of the model is to see which utility executives are adding value by skillfully allocating capital and which are merely riding the coattails of larger factors beyond their control. And that’s exactly what utility investors need to do to prepare for rising interest rates.

For instance, it’s definitely no coincidence that two of our favorite electric utilities rank among the top 5 in this year’s Fortnightly 40.

Who’s Better, Who’s Best?

But rather than rest on our laurels, we’re interested in seeing whether the Fortnightly 40 reveals any compelling companies among the utilities we don’t already own.

One approach is to simply start at the top. And while a top-ranked company can sometimes falter shortly thereafter, in this case the Fortnightly 40’s No. 1 company this year also occupied the top spot last year: Questar Corp. (NYSE: STR).

In fact, Questar has ranked within the top 3 of the Fortnightly 40 in four of the past five years. Clearly, its high ranking is no fluke.

Based in Utah, the $3.7 billion company is primarily a natural gas distributor (59.7% of full-year 2014 revenue), or local distribution company (LDC), which also develops and produces most of the natural gas (24% of revenue) it sells to customers.

The integrated gas company also owns and operates midstream energy infrastructure—a small network of interstate pipelines out west (16.4% of revenue).

Interestingly, Questar dovetails with an investment theme that we’ve detailed in a number of articles over the past couple of years: the ascendance of natural gas as the fuel of choice for power generation.

As part of this theme, last week we delved into pure-play LDCs, an investment play that’s rapidly vanishing.

While Questar has an unregulated energy production segment, it’s worked out arrangements with state regulators in Utah and Wyoming that allow it to earn utility-like returns from this business without being subject to full regulation or having to file regular rate cases.

The rationale is that since the vast majority of natural gas production serves its regulated LDC, Questar should be allowed to recover its costs of production while receiving after-tax returns on its investment base.

With natural gas demand expected to grow in the coming years, LDCs own an increasingly valuable part of our nation’s energy infrastructure. And Questar could very well attract attention from deep-pocketed suitors in its own right.

At the moment, however, Wall Street analyst sentiment is relatively tepid, at two “buys,” six “holds” and one “sell.”

The company has certainly generated strong dividend growth, with a payout that’s risen 9.1% annually over the past five years. And the payout ratio is a conservative 58.2%.

But at the moment, Questar’s future growth trajectory looks relatively flat. The consensus forecast is for earnings per share to grow 3.7% annually over the next five years.

However, muted expectations also mean the stock is trading at a moderate discount to its LDC peers. Questar has a price-to-earnings ratio (P/E) of 16.4, one of the lowest among its peers, compared to an average P/E of 21.5 for the category as a whole.

Perhaps that’s also a function of the fact that Questar’s diverse ventures mean it’s not quite a pure-play LDC.

Whatever the reason, we’ll be keeping a close eye on Questar. It’s got the right stuff in a number of areas, and at the right price it could very well merit inclusion in one of our portfolios.

Indeed, it’s hard to ignore a high-quality company like Questar, especially when its stock has a forward yield of 4%.

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