Utility Stocks: Income for Investors with Low Risk Tolerance
Many of you have heard me prognosticate about the safety provided by the utility sector for the past several years, particularly since the 2011 market correction. I have been preaching about the stability these dividend stalwarts should provide us in the event of another correction, or even worse, a bear market.
Well, we finally got a correction and (Hear! Hear!) our utility stocks have indeed provided us the desired counter-balance to the more cyclical companies. While we are not allowed to give you performance numbers from our managed portfolios, we can look at the widely followed published indices.
In the third quarter, for the three months ending September 30, the broad market S&P 500 Index LOST 6.94%, or $6,940 in a hypothetical $100,000 portfolio. The Dow Jones Utility Index, on the other hand GAINED 4.82% or $4,820 in a hypothetical $100,000 portfolio, an $11,760 difference between the two. Here we must point out that past results may not be a good predictor of future results, but you get the point… utilities can make a huge difference in an investment portfolio.
WHAT DO WE LOOK FOR?
Long-term investors looking for secure income that can grow faster than inflation should consider utility stocks that possess certain qualities. Let’s peel back the onion and look underneath the surface of a utility company.
VIRTUALLY NO FOREIGN REVENUES. In an environment where there is so much uncertainty in foreign markets, most utilities offer almost no exposure to the currency and political risk associated with foreign investments. As many of you know, we have never been comfortable with the additional risks that go with foreign investments, but it is difficult to find well established U.S. companies that don’t have sales outside the U.S. Utilities virtually remove that concern from an investment portfolio.
REGULATED VS. UNREGULATED. Historically most utility companies have been regulated by the states where they operated. However, in the 1990s someone decided that it would be a good idea to allow some electrical distributors to build power generating plants and sell the power across state lines and into a competitive market. BAD IDEA! Enron was born in that environment and most of us remember the disaster that turned out to be.
There are still several non-regulated “utilities” that sell their power into the competitive market and, as a result, the electricity they sell is now a commodity, and commodities can be very volatile. Their stocks have become volatile as well. REGULATED utilities, on the other hand, have a territorial monopoly which allows them to distribute and sell electricity or natural gas into a protected territory without competition.
Federal and State regulators allow these utilities to earn a fair rate of return, currently about 10%, on their capital infrastructure expenditures which are imbedded in consumer rates, and in exchange no other companies are allowed to compete in their protected territory… in our opinion a MUCH BETTER BUSINESS MODEL to invest in! These companies are the ones we believe make the best investments.
FAVORABLE REGULATORY ENVIRONMENT. Another quality we have found to be important is to focus our efforts on utilities that operate in jurisdictions that understand businesses and are reasonable in the rates they allow the utilities to charge their customers. As an example, utilities in California and the Northeast are facing regulators that are not particularly accommodating to the businesses that operate in their states, primarily because of political pressure from the voters.
In general, we prefer the “RED” states of the union… particularly the Southeast. Generally those states are still favorable to reasonable requests from the businesses in their states and allow the rates to reflect the costs of doing business there.
POSITIVE DEMOGRAPHICS. Another condition important to a utility company is that they operate in territories that have a GROWING POPULATION. If a utility company is trying to operate in an area that has a stable or falling population, then their expenditures are being spread over a shrinking customer base, which tends to put pressure on earnings (and dividends).
A utility company operating in a growing economy will continue to expand their infrastructure and distribution system to accommodate the additional customers and be able to earn that 10% (or so) on the investments they make to accommodate the additional customers. As a result, utilities in growing areas tend to be able to raise their dividend periodically… a very important quality to an investor!
ELECTRICITY OR NATURAL GAS? Both electricity and natural gas can make excellent investments, but there are some important differences. Electricity is used year-round for heating, cooling, lights, and many, many other uses, so electrical power usage does not tend to fluctuate much from season to season and year to year.
On the other hand, because most natural gas is used for heating, natural gas is in much higher demand in the winter time than in the summer. As a result, if the winter is warmer than usual the earnings of the gas companies are not as good that year.
As the price of natural gas has fallen as a result of the energy revolution going on in the United States, and because of increasing pressure from the EPA to reduce emissions from power plants, utilities are shutting down their old coal plants and replacing them with plants powered by natural gas in increasing numbers. This is very positive for the revenues of the gas utilities and the dividends they pay their investors.
Another surprise resulting from that recent trend is that now one of our big electrical utilities just decided to buy the natural gas utility in their territory and “cut out the middle man!” This has increased speculation that other gas utilities will be purchased by the electrical utilities, resulting in a premium being paid to the shareholders of the gas utilities.
Considering these recent trends – and since I haven’t found a weather forecaster yet who I would trust with my investment portfolio – I would not recommend a portfolio consisting exclusively of gas utilities; it should be diversified with both gas and electric utilities.
WHAT ABOUT RISING INTEREST RATES? Investors that have long owned utility stocks have discovered that the utility sector has a tendency to struggle every time there is the threat of a rate hike from the FED. Granted, the reason many investors have moved to utilities is to earn the yields needed to fund their retirement income needs, but if interest rates on bonds and CDs rise to competitive levels, some investors will naturally go back to the comfort of the fixed-rate investments, and sell their utility investments.
However, we believe it will require a much stronger economy to produce a sustained rise in interest rates. In a strong economy, utility companies benefit from stronger demand for electricity and natural gas and historically have experienced earnings growth, which they then pass along to investors as higher dividends. Therefore, we believe that most conditions that would cause interest rates to rise would also be beneficial to earnings, offsetting the pressure on utility stock prices.
CAN UTILITY STOCKS REPLACE CDs? Given the level of risk we believe an investor is actually exposed to in a diversified utility portfolio, we believe that utilities can appropriately replace most CDs and bonds for many investors. Instead of fighting the ups and downs of CD rates, we believe the steady increase in dividends year after year from a properly constructed utility portfolio provides a more pleasant retirement income stream.
WRAP UP
If you are still struggling with the lower income provided by your CDs, give us a call and let us provide you with more information about our income alternatives. We believe we can help provide a more reliable income source for you.
Sincerely,
Dave Crouch Cherie Hammond, CPA
Registered Principal Financial Advisor
Financial Advisor
"The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of the author and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Dow Jones Utility Index is a price-weighted average of 15 utility stocks traded in the United States. Inclusion of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.
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