Utilities deliver gains in declining market
There’s plenty to like about utility companies. Investors looking for stability will find their stock returns aren’t as choppy as the broader market, and they are a source of reliable dividend income.
Those traits are an outgrowth of the typically stable demand for electricity and natural gas. Homeowners and businesses keep the lights on, and the heat or air-conditioning running, in good economic times and bad.
Government deregulation of utilities has shaken things up, but it’s still a stable industry compared with most. The relative predictability of utility profits means stocks tend to follow a steady path of modest returns, and few of the surprises that can make stocks in other industries zigzag.
Utilities have topped the charts in this year’s market decline. Stock mutual funds that specialize in utilities are the top-performing stock mutual fund category, with an average 4.2 percent return, according to Morningstar. Nearly all other fund categories are down, and the Standard & Poor’s 500 stock index has lost 3.4 percent, including dividends.
Utility stocks posted unusually strong gains as the broader market tumbled in August. Shares of Consolidated Edison, a New York energy utility, jumped 6.9 percent, while electric utilities American Electric Power and Southern Co. were up nearly 5 percent.
Investors have recently bid up utility stocks because they are seen as a safe investment when the rest of the market is declining, Morningstar analyst David Kathman says.
Another plus? Their dividend yields look especially appealing now. The average dividend yield of the 33 utility stocks within the S&P 500 is 4.4 percent. That’s twice the average yield of the index. By comparison, the 10-year Treasury bond offers only around 2 percent.
But, in typical fashion, utility stocks haven’t participated in as much of the market’s rebound since March 2009. They are up about 50 percent since the market bottomed out, yet that lags the 80 percent gain for the S&P 500 through the end of August.
Despite utility stocks’ recent strong performance, there’s reason to believe it may not last. That’s because Wall Street analysts are less optimistic about their earnings prospects than they are for other industries. On average, analysts expect utility earnings to decline 2 percent next year compared with this year. Earnings across the S&P 500 are forecast to rise an average 14 percent.
Here are three things investors need to consider about utility stocks and the funds that invest in them:
How much should you invest? Utilities make up about 3.7 percent of the market value of the S&P 500 index. If you invest in a fund that tracks that index, you have a built-in stake. Many diversified funds also invest in utilities. If you want to check your total exposure, Morningstar’s website offers a tool called Instant X-Ray to provide a snapshot of holdings across your portfolio. A utilities investment a few percentage points above 3 or 4 percent of a stock portfolio may be appropriate if an investor is in or near retirement.
What are your investment options? Investors looking to invest in utilities can buy individual stocks, or invest in nearly two dozen mutual funds that specialize in utilities. Some are low-cost index funds that passively track an index of utilities stocks. One such offering is Vanguard’s Utilities Index Fund, which charges an expense ratio of just 0.24 percent. Others are actively managed and pricier, because they rely on the expertise of investment-picking pros. Morningstar’s current favorite is Franklin Utilities. More than a dozen exchange-traded funds specialize in utilities, and charge low expenses because they track indexes.
Are there regulatory risks? Utilities remain one of the more heavily regulated industries, despite a trend toward deregulation. That means utilities stocks could depart from their generally stable trajectory if there are significant regulatory changes. Many utilities are trying to meet government mandates to go green. They are looking for ways to decrease reliance on non-renewable sources of energy such as coal and oil, and expand use of renewable sources such as solar and wind power. Regulators also have imposed requirements that utilities improve the reliability of the electricity grid.
John Kohli, manager of Franklin Utilities Fund, says such requirements present growth opportunities for many utilities.
Although the utilities must increase spending to meet the mandates, they typically can recover the higher costs through rate increases passed on to customers, he says.
However, regulators could become less inclined to approve such rate increases if the economy slips back into a recession, Kohli says. If that happens, regulators may want to protect consumers from rate hikes, given the other economic stresses.
But on the whole, Kohli sees opportunity for utilities to become more profitable, as they invest more to make their operations more environmentally sensitive, reliable and efficient.
“Fundamentally, the sector is in good shape,’’ he says, “and we expect decent growth for the next decade at least.’’