Utility stocks remain a consistent and income-producing investment because these companies still provide dividends.
Since utility companies are part of a regulated industry where the cash flow remains predictable, they can also help diversify a portfolio.
Here are some things investors need to know about investing in utility stocks:
- Why utilities remain a good addition.
- Risks utilities face in bear market.
- How to add utilities to a portfolio.
- Advantages of utility stocks.
Why utilities remain a good addition
Utilities can be a good choice for some investors seeking income or diversification from the broader equity market since the dividend yield of utilities is 3.6%, the highest of any sector, says Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley business.
The sector also has the lowest beta to the S&P 500 (.SPX) at 0.43. Since utilities generate the highest percentage of domestic revenues at about 95%, this industry is uncorrelated to international markets, especially emerging markets, she says.
"Utilities still have pretty fair valuations with a 16.9 times forward price-to-earnings ratio compared to its 10-year average of 15.8 times," Gunzberg says.
Whether the markets have reached their bottom or will lose gains remains unknown as unemployment levels rise, but stocks continue to rally.
"If you are an investor that is concerned that we haven't seen the bottom of the markets given the coronavirus scare, then utilities may be a good thing to overweight in your portfolio," says Derek Horstmeyer, an associate finance professor at George Mason University in Fairfax, Virginia. "If we were to see another crash in the markets like we saw in March, utilities have less crash risk than other sectors, so we should not see as much downside risk with them."
Utilities can offer lower volatility and a reliable dividend yield.
"During times of crisis, these businesses suffer very little financial or operational impacts relative to companies in other sectors," says Shawn Cruz, senior manager of trader strategy at TD Ameritrade.
Investors who are seeking to position their portfolios more defensively or reduce volatility should turn to utilities because they provide an attractive option, says Jean-Hugues de Lamaze, senior portfolio manager at Tortoise Advisors in London.
The earnings risk is minimal and less than 5% in this current environment compared with a 30% potential decline for broader S&P 500, he says.
"Looking further ahead, we fully expect secular growth opportunities in this sector, related to decarbonization and infrastructure build-out to accommodate renewables that will be concentrated on again by investors," he says.
Investors who believe that the current recession will last longer than the six-month period some economists are anticipating should increase their allocation to the utilities industry, says Charles Self, chief investment officer at iSectors, an investment manager in Appleton, Wisconsin.
"Utilities tend to start outperforming as economic growth slows like it did in 2019," he says. "Research shows utilities will perform their best relative to other sectors in the recession itself."
Risks utilities face in bear market
While utilities are considered a defensive sector, the industry still has some risks. In this bear market, the "massive slowdown in business and potential changes in the future of the energy market present a number of unknowns for the future of utilities," Gunzberg says.
Utilities are capital-intensive industries that rely on debt financing to fund their projects, Cruz says. This can lead to increased volatility, and investors should avoid companies that carry elevated leverage.
"In a prolonged slowdown with elevated levels of unemployment, customers may have difficulty paying their monthly bills," he says.
The two primary risks utilities must cope with in this environment are lower electric sales, primarily among commercial and industrial customers, and an increase in bad debt expenses from customers not paying their utility bills, de Lamaze says.
The decline in electricity consumption has ranged from 5% to 10% because lower commercial and industrial sales have been partially offset by strong residential sales.
The industry can earn higher margins from residential sales, which helps to lessen the earnings impact, he says. "We expect utilities to see an increase in bad debt expense, however, in many jurisdictions these costs are recovered in future periods."
How to add utilities to a portfolio
Mutual funds and exchange-traded funds provide diversification and help investors avoid single stock risk. But all funds are not created equally, and some include companies with larger percentages of debt.
The Utilities Select Sector SPDR Fund (XLU) is the ETF that most investors use to track the sector, Cruz says.
The Vanguard Utilities ETF (VPU) is a passively managed fund that is a simple way for investors to capture the sector at a low cost and has 66 stocks.
"My favorite fund is the Vanguard Utilities ETF since it provides a tremendously diversified portfolio," Self says. "The combination of a low 0.10% expense ratio, unmatched trading liquidity and a current yield of 3.6% makes it the best utilities fund to own."
NextEra Energy (NEE), American Electric Power Co. (AEP), Duke Energy Corp. (DUK) and Dominion Energy (D) are some large utility companies.
NextEra Energy is a diversified utility consisting of regulated operations in Florida and a development company focused on wind and solar projects throughout the U.S.
Management has shown over time a "strong execution track record at its regulated utility and an ability to be ahead of the curve on wind, solar, and battery storage developments in the wider power sector," de Lamaze says. "The company confirmed its earnings guidance and a dividend growth rate of 10% annually through 2022. Not many sectors will be in a position to issue such a solid outlook in the current global economic context."
AEP is composed of regulated electric utilities serving more than 5 million customers across 11 states.
"We like the company's diversification across jurisdictions and its low-risk growth investments targeted towards replacement of aging transmission and distribution infrastructure," he says.
The dividends of utility stocks count as qualified dividends, which are taxed at the lower long-term capital gains rate when they are owned for at least 60 days following the ex-dividend date, says Stuart Michelson, a finance professor at Stetson University in DeLand, Florida. Bonds are taxed as ordinary income.
National Grid (NGG), Entergy Corp. (ETR), Brookfield Infrastructure Partners (BIP) and Southern Co. (SO) have all performed well with stock prices rising during the past five years and have high dividend yields of 5.4%, 3.8%, 5.7% and 4.5%, respectively, he says.
"The recent market downturn has also caused price decreases in these stocks, providing room for growth going forward," he says.
Advantages of utility stocks
The sector performs well in low-interest-rate environments because utilities already generate relatively high dividend yields of 3%, Gunzberg says.
"Investors may substitute utilities for bonds when rates decline severely or are very low," she says. "Utilities hold up when rates decline since falling rates may help their financing cost of high debt while demand remains steady in slower economic times."
Utility stocks represent basic services such as gas, electric and water that are always in demand regardless of the health crisis, says Mike Loewengart, managing director of investment strategy at E-Trade Financial.
In the recent downturn, investors could be seeking to incorporate less cyclical sectors like utilities into their portfolio strategy.
"Make sure to look at fundamentals of the company before diving into the investment," he says. "While utilities are considered less risky than tech stocks, they are not immune to market volatility. On the flip side, for investors with an appetite for more risk, the utility sector may not provide the growth potential you're looking for."
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