Utility stocks lived up to their reputation as a solid defensive play in 2018, and they have the potential to keep outperforming, especially if more volatility ensues.
“There’s still quite a bit of uncertainty as to where the market’s going to go,” says Christopher Muir, an equity analyst with CFRA.
Although the sector lagged behind the market early in 2018, it ended up with a total return of 4.1%, compared with minus 4.4% for the S&P 500 (.SPX).
Among the 11 sectors in the index, utilities placed second behind health care, which was up 6.5%. Only one other sector, consumer discretionary, eked out a positive return last year, up 0.83%.
Utilities started to outperform last fall, when the stock market began to slump.
That’s not surprising, considering that utilities are often coveted for their durable earnings and attractive yields.
These stocks, however, have outperformed over longer periods as well. The Utilities Select Sector SPDR Fund (XLU) has a three-year annual return of 9.93%, compared with 9.28% for the broader index. It has also outperformed over five- and 15-year stretches.
Phil Sundell, a portfolio manager at American Century Investments, says investors like utilities these days because “there’s certainty involved.”
He favors electric and natural gas utilities in regulated businesses. For the electric utilities, that includes power generation, transmission, and distribution. It also includes distribution for the regulated natural gas utilities.
Sundell maintains that on average, these companies can grow their earnings at annual clip of 5 to 7% for the next three to five years, up from 4% historically.
Part of what’s driving those earnings higher, he says, are major infrastructure investments in distribution grids to handle renewable energy, notably solar and wind. For the gas distributors, it includes replacing pipelines to make them safer.
Such investments allow utilities to earn a return on a larger asset base.
Still, “I wouldn’t say that valuations are particularly compelling at this point,” Sundell says, even though the industry’s fundamentals look sound.
The utilities SPDR fetches about 16.7 times this year’s profit estimates, down slightly from its five-year average of 16.9, according to FactSet.
Stocks that American Century holds include Atmos Energy (ATO), which is in the regulated natural gas distribution business. Sundell expects the company to grow its earnings, $4 a share last fiscal year, at a compound annual rate of 7% over the next few years. The company, based in Dallas, is replacing pipelines in several states, including Louisiana, Colorado, and Kentucky. The stock yields 2.3%.
Muir of CFRA expects the utilities in the S&P 1500 (.SPSUPX) to grow earnings by about 5% this year, helped in part by strong capital spending and higher customer rates.
He has a Strong Buy on FirstEnergy Corp. (FE), which gets a big chunk of its sales from regulated electricity distribution in six states, including New York, Pennsylvania, and West Virginia.
The company is focusing on regulated transmission and distribution businesses, which are considered less volatile than unregulated power markets. His 12-month price target is $42, more than 10% above a recent price of $36 and change. It yields 4.1%.
Of course, if stocks regain their footing and start to move up again, utility stocks could suffer “as investor rotate into riskier assets,” Muir cautions.
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