Wind turbines at a NextEra Energy wind farm.
Utility stocks don’t get much respect these days. The sector has lagged behind the market this year, unable to get traction. It has created an interesting buying opportunity for yield-hungry investors.
As of Oct. 21, the
Utilities Select Sector SPDR
exchange-traded fund (ticker: XLU), which serves as a proxy for bigger companies in that group, had returned about 9% in 2021, trailing the
S&P 500 index’s
22% gain. The utility sector in the S&P 500 is one of the worst performers year to date, along with consumer staples.
Utility stocks do pose real concerns for investors, among them a recent uptick in natural-gas prices and longer-term worries over the fallout from climate change and its impact on operators in certain parts of the country.
But with most of these stocks underperforming and bond yields still pretty low, there’s a sound argument that too many investors are overlooking utilities with solid fundamentals, appealing valuations, and durable dividends to boot.
“Most of those companies have reasonable payout ratios and the ability to grow that dividend in the mid-single digits,” says John Bartlett, president of Reaves Asset Management, which specializes in utilities and infrastructure investments. (A payout ratio refers to the percentage of a company’s earnings that’s paid out in dividends.)
*Based on consensus 2022 EPS estimates. Note: Data as of Oct. 21.
Bartlett adds that the utility stocks he follows recently had an average yield of about 3.5%. That’s much better than the S&P 500’s average yield of about 1.3%.
Bond yields have risen lately but remain pretty paltry by historical standards. The 10-year U.S. Treasury note’s yield was recently at 1.67%—still far below the yield of many utility stocks.
For all of the positives about utilities—including their ability to get through the pandemic last year with their dividends mostly intact—the market isn’t giving them much credit, as Barron’s pointed out in a stock screen published in September.
Headwinds for utilities include concerns about inflation, such as an uptick in natural-gas prices; rising interest rates; and market sentiment that’s shifted between growth and value stocks. Utilities, for the most part, don’t fall into either camp.
There are also longer-term risks to consider. They include “physical damage from climate change that is causing the customer bills to go way up” for certain utilities, says Stephen Byrd, head of North American research for utilities and clean energy at
Morgan Stanley. He cites as recent examples wildfires in California and floods in the Gulf Coast and Northeast.
Overall, though, Byrd is pretty upbeat on the sector’s prospects, including its dividends.
The stocks “haven’t really had a home,” says Claud Davis, co-manager of the $3.2 billion
fund (MMUFX), adding that investors “haven’t really considered utility stocks seriously.”
Utility stocks are often considered bond proxies, and a sudden surge in interest rates can make them less appealing to investors. But “under a more benign scenario where rates grow more slowly, you don’t necessarily end up with underperformance” for utilities, Davis says.
Another worry tied to inflation: Natural-gas prices have roughly doubled since early in the year to around $5 per million British thermal units.
But utilities generally can pass through a rise in natural-gas prices to customers. One potential concern, though, is that a surge in prices could make it harder for a utility to secure a rate increase to cover investments for its grid.
A recent research note by Pavilion Global Markets posits a scenario in which bond yields rise owing to inflation worries. “In that case, the bond proxies, particularly those able to pass on higher costs to consumers, like utilities, could start to do better than expected,” the firm observes.
Another potential plus for the sector is that utility stocks are cheap based on at least one metric. Last month, for example, S&P 500 utility stocks on average yielded 187 basis points more than the average yield for the 10-year U.S. Treasury note, according to MFS—a much wider gap than the 65 basis point average spread dating to 1998. (A basis point is 1/100th of a percentage point.)
The higher yields for utility stocks signify that they have underperformed. It also shows how low bond yields have fallen, their recent uptick notwithstanding.
The stocks aren’t necessarily that cheap when using price/earnings multiples, as the accompanying table shows. Four of the stocks fetch forward P/E multiples of at least 20, hardly cheap at first glance.
Byrd, however, doesn’t think the sector’s valuation is stretched, considering the durability of many utilities.
He puts the average utility yield at 3.4%, with annual earnings per share growth of 6%. “Most, if not all, utilities are going to grow their dividend in line with EPS,” says Byrd. “How many S&P companies in other sectors can say they have visibility of a 6% EPS growth rate for decades to come?”
Davis of MFS says the industry is in good shape “to make significant investments in the transition to renewable energy,” notably wind and solar power.
As of Sept. 30, the largest holding in the MFS Utilities fund was
NextEra Energy (NEE). The company owns FPL, a big regulated electric utility in Florida, as well as a large renewable-power business. The stock was recently yielding 1.8%, on the low side for a utility, partly owing to its big price gains in recent years.
Three utility stocks that have badly lagged behind their market this year are
WEC Energy Group (WEC),
Xcel Energy (XEL), and
CMS Energy (CMS), all of which were up slightly year to date as of Oct. 21.
Bartlett, however, expects all three companies to have dependable earnings growth in the mid-single-digit range. And “they have a nice solid dividend yield that’s going to grow over time,” he adds—though, because of the sector, they are all “just exactly the wrong stock to have in this stock market.”
Until that changes, investors are getting paid a nice dividend to wait.
Write to Lawrence C. Strauss at firstname.lastname@example.org