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Big yields in utility stocks

Focus on those opportunities with dividend growth potential in this sector.

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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

Find out why recent earnings growth has been historically strong in this sector.
Read the article

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.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Because of their narrow focus, investments in a single sector tend to be more volatile than investments that diversify across many sectors and companies.
Indexes are unmanaged. It is not possible to invest directly in an index.
Past performance is no guarantee of future results.
1. Performance represents S&P 500 Utility Index (utilities stocks) and S&P 500 Index (U.S. equity market). Source: Bloomberg as of May 10, 2013.
2. Payout ratio: The amount of corporate earnings paid out in dividends to shareholders. Source: Fidelity Investments as of May 10, 2013.
The S&P 500® Index, a market-capitalization-weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation. The S&P 500® Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS® utilities sector. The Bank of America (BofA) Merrill Lynch U.S. Corporate/Non-Financial Corporate BBB-rated Index, a subset of the BofA Merrill Lynch U.S. Corporate Master Index, tracks the performance of U.S.-dollardenominated investment-grade-rated corporate debt publically issued in the U.S. domestic market. This subset includes all securities with a given investment-grade rating of BBB.
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