Renewable energy remains a good bet, thanks to mandates in 38 states that require utilities to use more of it. Developers like Exelon Corp (NYSE: EXC) stand to win as low risk utilities with expertise.

 — Roger Conrad, Utility Forecaster

One of the surest ways to make money in the stock market is to isolate fundamentally strong businesses with sustainable dividends and wait. You heard me right: don’t buy right away but simply wait until Mr. Market delivers up some irrational sell-off in the stock that transforms a reasonably-priced stock into a bargain-basement stock.

Value Investors Benefit from Time Arbitrage

Why does the market periodically provide such gifts to patient, long-term value investors? Simple; many institutional investors (e.g., mutual funds and hedge funds) are pressured by impatient clients to deliver short-term results quarter after quarter and dump any stock that shows momentary weakness. These funds are more interested in fly-by-night momentum stocks promising a quick 3% gain than companies with sustainable competitive advantages that offer the potential for doubling or tripling over then next three to five years. Legendary investor Bill Miller calls this disconnect between short-term and long-term perspectives “time arbitrage.” Long-term value investors can take advantage of traders’ short-term thinking for significant profits:

The advent of hedge funds has made the market highly informationally efficient in the short run. The result is an opportunity for ‘‘time arbitrage,’’ which means that by lengthening the time horizon for thinking about a company’s results three to five years out rather than one year out, you can increase the probability that you will outperform.

Put somewhat differently, in a market that’s informationally efficient in the short term, thinking three years ahead is likely to be more effective than thinking three to six months ahead. This assumes that the investor is fundamentally oriented, not technically oriented, where short-term price trends drive behavior.

Exelon

A perfect example of time arbitrage occurred recently with Exelon (NYSE: EXC), a Chicago-based electric utility. On October 22^nd, the company released third-quarter results that showed adjusted earnings up more than 15% and revenues up more than 21%. Furthermore, the company raised the lower-end of its full-year earnings guidance from $3.80 per share to $3.95.

Sounds good, right? It was, but the stock proceeded to drop more than 5% over the next couple of days because analysts had expected Exelon to earn $1.12 per share rather than the reported $1.11 per share. The company missed estimates by a penny per share because of slightly higher than expected depreciation and amortization expense (a non-cash item). Does such a non-cash miss justify a 5% price decline in the stock? Absolutely not, yet value investors aren’t complaining; it was a great opportunity to pick up Exelon at a cheap, bargain price!

Nuclear Power is the Future of Energy

Value investors don’t care about penny misses; they look at the big picture, the long term. And the long-term picture for Exelon is extremely bright.  Exelon is not just your average, run-of-the-mill electric utility. It is the NUMBER ONE provider of nuclear energy in the United States with a 20% market share.  Nuclear power runs on uranium, a relatively inexpensive and abundant fuel source compared to fossil fuels like oil and natural gas.  According to one expert, there is enough uranium in the earth’s crust to power the world’s electricity needs for 160,000 years, which is a heckuva lot longer than current supplies of oil (50 years), natural gas (100 years) and coal (500 years) are expected to last.

Regarding supply, no new nuclear power plants have been built in the United States since the 1970s, so Exelon’s 11 fully-licensed and operational nuclear power plants are precious commodities that give the company a virtually unassailable competitive advantage. Combine this limited supply with strong support from the Obama administration for nuclear energy, and Exelon is well positioned for the future.

Exelon’s Hedging of Energy Prices Has Pros and Cons

The only problem for Exelon is a short-term one: natural gas prices are cheap right now, which makes electricity prices generated from power plants using natural gas highly competitive with Exelon’s electricity prices. Whereas Exelon is best known for its electric utilities in Chicago and Philadelphia, most investors are surprised to learn that two-thirds of Exelon’s earnings come from the sale of unregulated power in competitive electricity markets, including the PJM Interconnection that serves the Mid-Atlantic states of Pennsylvania, New Jersey, and Maryland.

Exelon is conservatively run, so it hedges its future electricity production in order to guarantee a minimum level of future revenues. This allows investors who rely on Exelon’s dividends to sleep well at night. On the other hand, hedging limits the company’s earnings growth if energy prices rise more than expected in the future. Exelon management tries to balance safety with growth by only hedging a portion of future production. As the year of production approaches, the company slowly increasing its hedges until virtually all production is hedged. Below is a table showing the company’s current hedges in place:  

Percent of Expected Generation Hedged

Virtually everyone expects natural gas prices to rise from their current low level in the coming years, including KCI’s energy expert Elliott Gue. Not only is demand for natural gas expected to rise as the economy recovers, but the cost of natural gas is expected to rise as a result of the Environmental Protection Agency’s (EPA) drive to regulate carbon dioxide emissions.  Back in December 2009, the EPA ruled that carbon dioxide is an air pollutant that can be regulated under the Clean Air Act. Although carbon cap-and-trade legislation died in the U.S. Senate this past summer, EPA administrator Lisa Jackson is planning to impose many of the same restrictions that the legislation would have. These regulations are sure to raise natural gas prices, which will allow Exelon to raise its electricity prices and enjoy higher profit margins.

The problem is that futures prices, which Exelon sells as a hedge, reflect current natural gas prices to some extent, so Exelon is forced to sell natural gas futures at low prices, which will hurt Exelon’s earnings over the next few years as these hedges replace earlier hedges sold at much higher natural gas futures prices. Investor expectations of lower Exelon earnings in the 2011-2013 period are what has caused Exelon’s stock price to lag other utilities. But when you think about it, Exelon is being punished for being conservative and protecting its dividend. Short-term thinkers forget that the hedging approach of Exelon’s “Power Team” has created close to $3 billion in incremental value over the past two years as natural gas prices fell. As Exelon CEO John Rowe stated in the latest conference call:

We don’t need a big recovery in gas markets to maintain our dividend at its current level. And if gas prices stay where they are now forecasted, I believe we can maintain the dividend and continue our planned capital expenditure programs as well of course as meeting our pension obligations.

At a sustainable 5% yield, Exelon’s stock is very enticing and long-term investors look past the temporary earnings hit coming up over the next few years.

Investors Hope For a Change in Illinois’ Governor

Another possible catalyst for Exelon involves improvements in its regulatory environment. While Utility Forecaster‘s Roger Conrad says that Exelon “enjoys solid regulatory support in Pennsylvania,” Illinois is a different story. The Illinois Commerce Commission (ICC) has been giving Exelon a hard time on some of its cost recovery requests. Illinois’ current Democratic governor Pat Quinn is anti-business and has supported the ICC’s tough stance. But polls show that Republican Bill Brady is likely to oust Quinn in the November election, and Brady is pro-business. University of Virginia professor Larry Sabato’s Crystal Ball website has the Illinois gubernatorial race “leaning Republican.” If Brady wins, look for Exelon’s cost recovery in Illinois to improve substantially by $100 million or more.

No doubt about it, Exelon’s future is bright.  Prescient investors who have a long-term perspective will do extremely well owning Exelon stock and enjoy a 5% dividend waiting for the story to play out. As Exelon CEO John Rowe stated in the conference call:

The upside in future energy and capacity prices are clearly positive for Exelon and its long-term value. We don’t know exactly how much or exactly when; if we did, we would love to tell you; you don’t know exactly how much or exactly when. But we know and you know that this is the fleet that is best positioned to prosper in the second half of this decade. That is why our operating performance, our healthy balance sheet and the yield from our $2.10 per share dividend are all the more important now, simply put Exelon offers the best upside in our industry and a dividend yield of nearly 5% as we go forward.

Utility Forecaster Loves Exelon

The “second half of this decade” is when Exelon will truly shine and that is what investors should focus on. Exelon is one Roger Conrad’s absolutely favorite stocks and is a “core” holding in Utility Forecaster‘s “Growth Portfolio.”

Given Exelon’s bright future, it’s no wonder that Roger considers it a growth stock even though it currently pays a healthy 5% dividend. The stock currently changes hands for a little more than $41 and Roger recommends buying it up to $50.

===============================================================================