That's certainly the case with energy, communications and water utilities, which hold franchise positions in services that are absolutely essential to modern life. After two decades of control by pro-deregulation forces in Washington, DC, there's competition in segments of their businesses. But for the most part, utes are
natural monopolies with little risk of losing much ground.

The energy transmission and distribution business, for example, remains in the hands of regional monopolies. The power generation business is currently 60 percent in the hands of regulated producers, and most of the rest is pumped out by subsidiaries of dominant utilities. More than two decades after the breakup of Ma Bell, her offspring are bigger than ever. And water is exclusively in the hands of municipalities and regulated companies.

Dominating essential services has ensured strong cash flows for utilities over the years. And even when companies have made horrendous mistakes, they've been able to recover their financial health by relying on their regulated franchises. In fact, betting on their recovery has been one of the surest roads to multiplying
wealth on Wall Street.

Of course, there are times when even the strongest companies can be tripped up by regulatory changes. Power utilities were slammed in late 1993 and well into 1994 by fears that government would change the rules to favor non-utility power producers in the name of "competition" and cutting rates. They were hit again in 2001-02 from concern that government would punish them for the collapse of Enron. Communications giants took a hit this year, as some panicked that the Democratic takeover of Congress would turn the rules against them.

When you invest in a regulated industry, you can count on a degree of stability that's unmatched by companies in unregulated sectors. But you've got to be prepared to take the good with the bad.

I've always strived in Utility Forecaster (http://www.utilityforecaster.com) to focus on states where utilities and regulators have enjoyed a cooperative relationship, as a way of avoiding unpleasantness. And to a large degree, it's the same states that cause the greatest difficulty, while others reliably have their acts together.

Sometimes, however, the changes or potential moves are so far-reaching that they can't help but take the entire sector down, at least in the near term. At such times, it's tempting for investors to throw in the towel as panic levels reach a fever pitch. But historically, that's proven to be the absolute worst possible decision. Often it's made sense to do some swapping around at the bottom. But generally, the right course has been to stick.

That was certainly the case for utilities in late 1994, when many investors abandoned them due to deregulation fears. As it turned out, even California's plan was moderate and within a couple of years, the sector was pushing up to new highs.

For utilities, the last regulator-induced selling wave began in early 2001. That's when Gray Davis, then governor of California, failed to move quickly enough to prevent the bankruptcy of PACIFIC G&E (NYSE: PCG),  the state's largest utility, and the near - insolvency of Southern California Edison, its second-largest and a wholly-owned subsidiary of EDISON INTERNATIONAL (NYSE: EIX). Utilities had been forced to pay soaring prices for power purchased through a faulty system that was easy for sellers to rig, even as
they were unable to pass along costs because of a rate freeze.

The Pacific bankruptcy induced Davis to file a claim against the state's power producers for $9 billion in alleged damages. That set off a wave of similar claims against utilities nationwide, which triggered a series of investigations of accounting practices. The result was a wave of credit rating downgrades and tumbling share
prices that left some two-dozen companies at the brink of bankruptcy by late 2002.

As the writer of an investment newsletter devoted to utility stocks at the time, I can testify to the market mood of rank despair. Some investors smelled opportunity, and today are far richer for acting on that sense. But the prevailing emotion conveyed in letter after letter, phone call after call, e-mail after e-mail, was fear and panic.

Blaming the capriciousness of government regulation, more than a few readers professed they would never trust utility stocks again. Their selling price was a generational bottom.

Since late 2002, the UTILITIES HOLDRS (AMEX: UTH) trust, which represents a basket of the largest energy utilities, has soared from a low price in the mid-50s to over 130 today. Stocks once left for dead--like CMS ENERGY (NYSE: CMS), SIERRA PACIFIC RESOURCES (NYSE: SRP) and WILLIAMS COMPANIES (NYSE: WMB)--have soared five-, ten- and twenty-fold from the bottoms they reached when some investors were selling at any price. And with underlying fundamentals continuing to strengthen, utilities will very likely post a fifth consecutive year of robust returns in 2007.

WHY THE HISTORY LESSON?

Utilities' phoenix-like recovery over the past four years is no mere answer to a trivia question. Rather, it provides one of the critical lessons of market history that come along only so often for investors of all stripes and persuasions.

One element is, of course, diversification--a virtue I've repeatedly preached in this advisory. The worst effects of utilities' crash in 2001-02 could have been avoided, for example, by owning bonds, real estate investment trusts and other income investments as well. That formula helped the Personal Finance (http://www.pfnewsletter.com) Income Portfolio weather the storm despite being stuck with several horrific individual situations.

Just as important, having a solid stake in these alternatives made it infinitely easier psychologically to handle the pain from the catastrophe in utilities. That made it possible to hold onto and even to buy quality utilities when others were screaming the end of the world for the sector was near.

Diversification will be the key to avoiding the worst of future market debacles. In fact, an exodus of funds from a battered sector frequently pumps up values in others, so a diversified portfolio can actually gain when one of its components declines.

The other element of the lesson of regulated utilities' fall and subsequent rise is that what the government gives a regulated industry it sometimes takes away--but that things can turn back on a dime. The final result is almost never as bleak as it looks at first. Instead, chagrined by the carnage, government typically moderates its stance. The market adjusts and perceives the values and the sector recovers.

The last great debacle to hit income investors is, of course, the one we're facing now: the pasting taken by Canadian royalty and income trusts since Halloween, when Finance Minister Jim Flaherty announced a proposal to tax them as ordinary corporations beginning in 2011.

Canadian royalty and income trusts aren't regulated in the sense that US utilities are. But their heretofore-privileged tax status has been courtesy of the Canadian government. As a result, they've always been very much at the mercy of regulation.

About a year ago, the then-Liberal government announced it was launching a consultation period with the goal of leveling the playing field between trusts and ordinary corporations. The idea was that companies converting to trusts were a drain on Canadian government revenue and that something had to be done to stem the flow.

As it turned out, the resulting firestorm caused the Liberal government to withdraw the proposal. The Liberals were subsequently defeated by the Conservative opposition in the election a few months later, who at the time promised never to change trusts' favorable taxation.

The Conservatives' Halloween flip-flop triggered a massive one-day slide in the prices of Canadian royalty and income trusts. They proceeded to drop further over the next couple of weeks, finally bottomed and have been inching higher during the past month. And just like the utilities' crackup of years past, the psychological impact continues to linger.

As the editor of a newsletter, Canadian Edge (http://www.canadianedge.com), devoted wholly to income and royalty trusts, I've had the same opportunity to see investor psychology up close that I had with writing Utility Forecaster during the Great Utility Bear Market of 2001-02. There are obviously differences, but
the many more similarities.

For one thing, the mood is grim. Everyone feels horrible about losses, including those still sitting on gains. Most feel cheated by the Canadian government's flip. Some have sold and are no doubt resolved never to go near the sector again. Others are holding and hoping the government will completely reverse its decision, without taking a hard look at their holdings. Few can see any way they'll make back their losses and many are extremely nervous there will be future losses of even greater magnitude.

All of these are understandable emotions in the wake of what's happened. Unfortunately, those who follow them aren't going to weather this thing.

The clear lesson of the regulator-fueled utility stock crashes of the early 1990s and early 2000s is this: Things were never as bad as they first appeared. All the forecasts of stranded costs triggering utility bankruptcies proved ill founded. So did the fears of a ruinous nationwide regulatory crackdown on utilities after the Enron bankruptcy.

This past week, we got our first real indication that will be the case with the trust crash, as the Conservatives unveiled favorable rules for the proposed transition to the full taxation in 2011. Specifically, there's to be no tax penalty for conversions by trusts back to corporations, either before or after 2011. Also, the vast majority of trusts will be allowed to continue to do business as usual for the next four years.

In 2007, trusts will be allowed to issue up to 40 percent more stock for expansion. They'll be able to issue an additional 20 percent more each year thereafter until 2011. Share issues made to reduce debt--such as stock conversions from convertible bonds and preferred stocks--won't count toward the total.

Given that the best trusts don't issue a lot of shares anyway, even for growth, the clear implication is they'll be able to keep growing, producing a rising stream of cash flow that they can pay out to shareholders if they wish to. More mergers should also be tolerated, including several currently in the works that had been put on hold due to fears of stricter limits.

In 2003, when the Federal Energy Regulatory Commission (FERC) began hinting power producers owed California around $1 billion in refunds--as opposed to the $9 billion then-Governor Davis was demanding--the worst case for utilities got better. For the trusts, the Canadian government's proposals for trusts' transition essentially mean that the worst case for that group has suddenly gotten better.

We're likely to have to wait a few more months to see what other changes to the government's plan gain traction. The good news is the market is pricing in the worst case as it has all along. That means even if nothing else happens, prices of strong trusts will hold up. And if anything else does go in a positive way, we can expect more gains.

As was the case for utilities in 2003 and 2004, the pessimism of the trust market gives us a lot of upside with relatively little downside. And don't forget that some trusts are better positioned than others, or that there are some 250 different trusts--each with its own potential plan for future taxation. As the utility debacle of 2001-02 clearly showed, it's always darkest before the dawn. When you feel at your worst is precisely when there's most likely to be a bottom, and when it makes the least sense to sell. The fact that most trusts have been in a slow recovery over the past month is a very good sign the worst of this debacle is rapidly receding into the rear-view mirror. And as long as you have trusts as part of a diversified portfolio, you have little to fear by going along for what could be a very lucrative ride in 2007 and beyond.

As for regulation of utility stocks, there's no doubt in my mind that more challenges lie ahead for the sector. Over the next decade, companies will have to invest billions of dollars in new power plants, high voltage transmission wires and environmental controls. Regulation of carbon dioxide appears to be a certainty as well. The price of needed power plant fuels--coal, natural gas, oil and uranium--is likely to go up as well.

That adds up to higher costs that utilities will have to control. Inevitably, they'll have to come to regulators to recover at least some of those expenses in rates. How they fare in those cases will to a larger extent determine how healthy their finances will be, and what kind of dividends they'll be able to pay.

With deregulation dead in the water and even former advocates like ELCON (http://www.elcon.org) calling for more regulation, I'm less concerned about big sweeping pronouncements wreaking havoc, as was the case during the '90s. There's just not a lot of appetite out there for imposing wrenching industry changes.

There are and will be trouble spots, however. And it will be critical to avoid them where possible. One of these now is Illinois, where the state legislature will meet next month to vote again on freezing utility rates until 2009. Such a move would expose regulated utilities to rising costs with no way to recover them, likely plunging the units into Chapter 11.

The bill was voted down earlier this month, buying the utilities some time to convince enough legislators to fail it again. This battle will be more difficult, owing to the fact that fewer votes will be necessary to win passage. Their success will depend on how the plans to phase-in the rate hikes approved by Illinois regulators this week are viewed by legislators.

Two utilities are affected: AMEREN (NYSE: AEE) and EXELON (NYSE: EXC). Exelon, however, can plunge its Commonwealth Edison unit into Chapter 11 with little real impact on earnings. Exelon is projecting a huge earnings gain in 2007 and recently raised its dividend 10 percent, even while noting the risk of a regulatory reversal. Ameren, on the other hand, barely covers its dividend and will almost certainly take a major hit.

Another battleground for early 2007 is at the Federal Communications Commission (FCC) over AT&T'S (NYSE: T) proposed merger with BELLSOUTH (NYSE: BLS). This week, the FCC's newly appointed third Republican again recused himself from the case. Aside from begging the question once again why the president appointed him in the first place, the recusal again leaves the FCC deadlocked at 2-2.

The FCC's two Democrats are again ratcheting up their demands that AT&T agree to the principle of net neutrality as the price of their approval. The two Republicans are opposed, as are a large number of
members of both parties in Congress.

With all other approvals in, I very much doubt AT&T will punt the merger over this issue. But the company isn't going to give in fully on the issue either, as the full-blown concept advocated by GOOGLE (NSDQ: GOOG) and others would take away a considerable amount of its control. I expect to see a compromise hammered out in coming weeks and the deal approved. Again, however, a failure to pass the deal will signal tougher times ahead, at least for some companies.

The bottom line: It's foolish to ignore regulated companies as investments just because the government wields considerable influence over them--even if the government itself is less than ideal. Regulated companies have stability non-regulated rivals can only dream about, and there are often very strong bargains.

But it's equally foolish to own regulated companies and not keep up with their regulation as best you can. And it's critical to diversify, so you can be protected against those disasters that come along every so often, and then mentally prepared to participate in the inevitable recovery.

That's a lesson that will serve anyone well in the year to come, and well beyond.

© 2006 Roger Conrad
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