So far in 2013, a lot of new capital has been allocated to utility stocks with little discretion from investors, the majority of whom are likely looking for the most attractive yields in a prolonged environment of low bond yields. Amid this increased investor demand, there has been little performance differentiation between low-quality and high-quality utility companies. Stronger demand has helped utility stocks advance 13.6% year to date through May 10, 2013, compared to a 14.6% advance for the S&P 500 Index.1
With traditional price-to-earnings valuations suggesting utility stocks are somewhat expensive, investors may be best served going forward by focusing on utilities with the highest rate of dividend growth. Historically, utility companies that have demonstrated the ability to grow dividends the most significantly over time have tended to outperform.
State of the utilities sector
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Looking at rolling three-year periods going back to 2001, the stocks of utilities in the top tercile of dividend growth generated the best average annualized returns relative to the broader group of utilities over this period (see the chart below right). Going forward, it is reasonable to expect that companies that are able to grow their dividends the fastest may outperform as well.
Identifying regulated utilities with the fastest–growing dividends
On average, the payout ratios of regulated utilities vary in a range from 60% to 65%.2 There are no regulated utility companies with extremely low payout ratios, which would allow a company to simply increase its dividend payout by increasing its payout ratio. As such, the companies best equipped to grow their dividend payouts are likely to be those with the most attractive business models or regulatory structures.
In our view, utility companies with better business models generally can be characterized by two traits: structural spending opportunities and timely recovery of investment. For example, a regulated utility that has a structural spending opportunity may be: 1) building transmission to link up renewable sources of energy with regions that have insufficient transmission capability or power supply (i.e., load pockets); 2) building new power generation because the utility is located in a resource-constrained area; or 3) constructing a natural gas pipeline.
Equally important, a company that makes a capital investment in one of these aforementioned areas is better positioned to raise its dividend payout if it has the ability to raise pricing and earn a higher amount of revenue on its new investment as quickly as possible. The common denominator that allows both traits to be important to investors is favorable regulatory oversight.
Consider the following business models:
- Transmission improvements
A favorable regulatory environment can allow a regulated utility that focuses on electric power transmission to quickly recoup a return on its capital investment. Going forward, I expect an increase in spending on power grids and transmission lines, driven by the need to address significant grid reliability issues. Additional spending is also likely to be driven by plant shutdowns mandated by the Environmental Protection Agency (EPA), and a desire to avoid large-scale blackouts. Also, transmission spending will be driven by the build-out required to connect renewable resources (e.g., wind and solar power development) with urban regions that have high demand for power.
Transmission is regulated by a U.S. government body known as the Federal Energy Regulatory Commission (FERC), and thus it is not subject to the intense politics and rate debates on new projects at the local government level. Once new capital investment in transmission is approved by the FERC, it automatically translates to higher power pricing. This level of federal regulatory oversight results in minimal risk to a utility of not recovering a return on its investment in a timely manner.
- Natural gas infrastructure development
Another compelling business model is the build-out of natural gas infrastructure, such as natural gas pipelines, which are also regulated by the FERC. The abundance of natural gas that has been discovered in shale basins in certain parts of the U.S. during the past few years is fueling natural gas infrastructure development to help transport the relatively inexpensive commodity around the country and reduce overall energy costs for consumers. U.S. energy independence and lower-cost energy for more Americans are both initiatives that typically receive little resistance from regulators or politicians.
When a pipeline is built by a utility, contracts are negotiated with energy producers that purchase a certain amount of the pipeline’s capacity. The utilities that own the pipelines typically get paid by energy companies regardless of whether natural gas is flowing through the pipeline. As a result, there is little cyclicality in the pipeline’s revenue stream, and more stability in the earnings produced by these companies, both of which are supportive of dividend growth.