The Dow Jones Utilities Average has been under pressure since late January 2015, when concerns about the Federal Reserve raising interest rates gave investors a reason to take profits and put the brakes on a rally that had pushed the index to a record high.
Although the Dow Jones Utilities Average caught a bid in early July, recent weakness in the broader market has hit the sector, leaving the index at roughly the same level as a year ago.
Conventional wisdom suggests that the Federal Reserve’s plan to normalize monetary policy could take utility stocks and other dividend-paying equities lower, while the recent selloff in China’s stock market and the Mainland’s apparent economic slowdown are also causes for concerns.
Given the circumstances, many investors have contemplated packing it in and waiting for better times—if they haven’t bailed already.
But investors shouldn’t pull the plug on their utility holdings. Instead, consider taking advantage of weakness in the broader market to add to or establish positions in our favorites.
Not only should this defensive sector hold its value better than most, but our top picks also have ample opportunity to grow their cash flow and dividends by investing in system upgrades and expansions.
Let’s take the commonly dispensed arguments for selling one by one.
An unsettled global economy has rattled the market’s confidence that the Federal Reserve will hike interest rates this month, though Fed Funds futures imply a 66 percent chance of the central bank announcing an increase at the December 2015 meeting.
Let’s assume that the Federal Reserve raise interest rates later this year and follows a strategy resembling the central bank’s most recent tightening cycle.
From June 2004 to June 2006, the Alan Greenspan-led Fed raised the benchmark interest rate from 1 percent to 5.25 percent. Over this period, the Dow Jones Utilities Average enjoyed one of its most profitable two-year runs of the postwar era, generating a total return of almost 62 percent. The S&P 500 returned less than 18 percent over the same time frame.
Why did utility stocks outperform while the Federal Reserve tightened credit conditions?The sector benefited from ongoing efforts to slash debt and operation risk, and the strengthening economy helped to bolster electricity demand.
This time around, the Fed’s rate increase will occur in the seventh year of a bull market; the last tightening cycle came barely a year into the recovery from the technology sector’s crack-up.
But one factor remains the same: Business fundamentals continue to strengthen in the utility sector, as management teams continue to cut operating risk, reduce interest expense and push out debt maturities. And sanguine relationships with regulators in all but a handful of states, most utilities can earn a fair return on their system investments.
These strengths suggest that the utility sector will hold its own, regardless of the Fed’s actions.
A slowdown in China’s economy carries important ramifications for the rest of the world.
Although the Shanghai Stock Exchange Composite Index has plunged after surging to its highest level since December 2007, it’s still quite a leap to suggest the country’s economy is in an irreversible tailspin.
And even if China’s economic challenges are as bad as some advertise, most US utility stocks focus exclusively on the domestic market.
Even AES Corp (NYSE: AES), which has a presence in Latin America and other overseas markets, generates a relatively reliable revenue stream from its international operations, thanks to its focus on regulated utilities.
China’s woes and economic weakness in Europe have raised concerns that growth in US gross domestic product could slow.
Utility stocks tend to fare better when the economy strengthens—one of the reasons that electricity demand has started to tick up in many parts of the country.
Slowing economic activity tends to reduce electricity consumption. However, the sector’s revenue doesn’t fluctuate to the same extent as in cyclical industries because these companies provide essential services.
The only time utility stocks got into trouble during an economic slowdown occurred in the early 2000s, when the sector had taken on excessive leverage and added riskier business lines to drive near-term growth.
Concentrated efforts to correct these past excesses meant that utility stocks survived the Great Recession with aplomb. And because many of these companies continued to grow their dividends throughout the crisis, investors flocked to the sector when conditions began to stabilize.
Proponents of distributed solar power have suckered all too many investors into their vision of a future where utility customers cut the cord and opt for rooftop solar panels, sending traditional power companies into a death spiral.
But SolarCity Corp (NSDQ: SCTY) appears to be the only company locked in a potential death spiral. For several quarters, the solar-power evangelist has lost more money with each incremental dollar of revenue.
Meanwhile, best-in-class utilities continue to invest profitably in solar power to grow their earnings.
Much of these capital expenditures have gone toward utility-scale installations that produce roughly four times as much power as an equivalent investment in rooftop solar panels. Some of these facilities go right into the utilities’ rate base, while others sell their output under long-term contracts.
Some utilities have also moved into distributed solar power and energy storage, taking advantage of their superior cost of capital and lower selling costs to win market share from SolarCity and other upstarts. In fact, many of these disruptors have formed partnerships with utilities.
In short, rising adoption of solar power has become an earnings driver for best-in-class utilities, not a threat to their survival—a point underscored by the recovery in electricity sales that many of the names reported in the second quarter.
Valuations in the utility sector looked stretched in late January 2015, when the Dow Jones Utilities Average hit an all-time high. In Conrad’s Utility Investor, we opted to take profits on several positions that had reached unrealistically high valuations.
These days, the Dow Jones Utilities Average yields 3.9 percent—in line with its average over the past 23 years. Meanwhile, the index’s price-to-earnings ratio of 14.8 is less than the long-term average of 16.1. The sector also trades slightly below its long-term price-to-book ratio.
Meanwhile, the recent resurgence in utility mergers and acquisitions suggests that industry executives regard valuations as favorable.
On Aug. 24, the day of the second leverage-induced flash crash, Southern Company (NYSE: SO) announced an agreement to acquire gas utility AGL Resources (NYSE: GAS) at a 40 percent premium. Conrad’s Utility Investor subscribers should check out Merger Madness for our in-depth analysis of this deal.
Southern Company expects this acquisition to accelerate its earnings and dividend growth—a clear sign that management views AGL Resources as a bargain. We expect more mergers and acquisitions activity over coming months.
Conrad’s Utility Investor subscribers should consult my special report—Top 5 Utility Takeover Plays—for ideas on how to play this trend. If you haven’t joined yet, click here to learn more about how you can save $100 on a one-year subscription.
By and large, Warren Buffett’s comment that utilities are a good business but not a great one rings true.
Investors can build impressive wealth over the long run by patiently reinvesting a rising stream of dividends, a strategy I continue to use in my personal accounts and have advocated ever since I launched Utility Forecaster more than 25 years ago.
My investment strategy hasn’t changed, but my address has: Conrad’s Utility Investor is the only place you’ll find my latest analysis and investment ideas.
How do utilities continue to deliver the goods year in and year out? These companies provide goods and services that are essential to modern life, a built-in advantage that has enabled them to come back from almost any crack-up—including those of their own making.
Utilities have focused on de-risking their operations and shoring up balance sheets in the decade and a half since Enron’s implosion, a trying time when many operators found themselves on the brink of bankruptcy.
This resilience suggests that utility stocks deserve a premium valuation to the rest of the market, especially at a time when the energy sector and emerging markets find themselves under pressure.
Of course, there’s no guarantee that the Dow Jones Utilities Average will continue the rally that started in early July. And it could be a while before the index surpasses the all-time high hit on Jan. 28, 2015.
But investors have every reason not to succumb to panic and sell their positions in high-quality utility stocks when the media stokes fears that rising interest rates will decimate the sector—market history tells us that these stories amount to sound and fury, signifying nothing.
Buying and holding best-in-class essential services companies has enabled patient investors to build sustainable wealth over the past three decades; we don’t expect that to change anytime soon.