Almost since Ben Franklin got a charge out of flying his kite, utilities have been a favorite industry for conservative investors. An investment in utilities is considered ''defensive,'' meaning you can be fairly certain it won't go bankrupt or cut its dividend, says John Slatter, a vice-president at Prescott, Ball & Turben, a Cleveland brokerage firm. Investors can also get tax-deferred income on yields that are typically above average - these days, about 9 to 11 percent.
And, with a technique known as ''dividend reinvestment,'' it is possible to reinvest up to $750 ($1,500 on a joint return) of utility-stock dividends, and not pay any tax until the shares are sold. When that happens, the profits are taxed as capital gains.
Although dividend reinvestment is especially advantageous when yields are highest, such yields are not guaranteed, Mr. Slatter cautions. There have been a few occasions in recent years when utilities, hit by high fuel costs, poor management, or low regulated rates have had to cut or eliminate their dividends. This possibility, though small, points up the need to shop carefully when looking for utility investments, Mr. Slatter says. While most people will need the assistance of a broker, Mr. Slatter offers some useful guidelines for making initial judgments.
One of the easiest ways to pick a good utility for investing, he says, is to ask what state it is in and if the state commission that regulates utilities and sets their rates is appointed by the governor or elected. If appointed for a specific period that does not coincide with the governor's term, the commission is less likely to be political and the utility is more likely to be profitable.
Some of Mr. Slatter's favorite states in this regard are Wisconsin, Indiana, and Texas.
''Anything in Wisconsin looks good,'' he says of that state's utilities. This includes Wisconsin Power & Light and Wisconsin Public Service Corporation.
One of his favorite utilities is Citizen's Utilities, which is based in Stamford, Conn., and has operations in 10 states from Vermont to Hawaii. Over 70 percent of Citizen's capitalization is represented by shareholders' equity, compared with 37 percent for most electric utilities. At some of the weaker utilities, he adds, this figure is as low as 13 percent. This strength was recognized last September when the utility's bonds were upgraded to AAA by Standard & Poor's.
One way utilities can cut their losses - but only on paper - is through something called AFUDC, or Allowance for Funds Used During Construction. Because most utilities are almost always in the process of constructing something to meet new power needs or replace old sources of supply, they are permitted to incorporate AFUDC in the profit-and-loss statement they show to shareholders.
However, Mr. Slatter says, this may mean the utility is paying its dividends out of principal, not out of earnings. So he suggests investors find out how much use a utility is making of AFUDC: the less, the better.
While many investors prefer dividend reinvestment as a way to defer taxes on their utility earnings, it is also possible to get periodic income from utility shares as well as a tax break. There are tax-deferred mutual funds that invest in public utilities and, after one year, pay shareholders on a monthly or quarterly basis.
In a recent issue of ''Investor News,'' published monthly by his firm, Mr. Slatter explains how this might work: If an investor put $50,000 in a fund selling for $10 a share, he would have 5,000 shares. In a year, assuming a 10 percent yield, each of those shares would be worth $11.
At that time, the investor could instruct the fund to liquidate 300 shares a year. At that rate, it would take 16.7 years to use up the investment. In the first few years, most of what the investor gets would be his own principal, making it nontaxable. The rest would be taxed as capital gain, where the maximum rate is 20 percent.
Or, an investor could stretch out this repayment many more years by requesting a specific dollar amount. In this case, the request might be for $4, 000 a year, or 8 percent of the beginning principal. Since the rest of the shares would still be earning interest, and as long as the fund's yield did not drop below 8 percent for a long time, the principal might never run out.
The funds that can be used for this purpose are American Birthright Trust, Chancellor Tax-Managed Utility Fund, the Tax-Managed Fund for Utility Shares, and Eaton Vance Tax-Managed Trust. A broker should be able to provide prospectuses on these funds.
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