Look to Utilities for Income, Especially in a Downturn
Utility stocks have disappointed this year, losing 5%, on average, compared with a gain of 5% for the S&P 500SPX +1.44% index. Although that’s frustrating for shareholders, there may be a silver lining: more attractive valuations and higher yields for investors looking for defensive plays if the economy deteriorates.
These stocks aren’t dirt cheap, even with the recent underperformance. The S&P 500 Utilities IndexSP500.55 +0.76% fetches about 18 times this year’s profit estimates, below its five-year average of 19.2 times, but in line with the market average. However, utilities yield 3.3%, on average, nearly double the S&P 500’s 1.7%.
Investors can pick up more income in cash proxies like money-market funds, six-month T-bills near 5%, or two-year U.S. Treasuries at 4.1%. But utilities should benefit from a smoother interest-rate climate once the Federal Reserve stops raising rates, possibly in the next few months. Utilities may also offer more capital appreciation than bonds if the economy weakens and investors shift to defensive stocks.
“If a rotation is going to occur, it’s likely because something gets worse, in which case you want to own defensive sectors,” says Liz Young, head of investment strategy at digital bank SoFi.
Moreover, utilities offer dividend growth, while bonds pay fixed income, based on their coupon rates. Eventually, bond investors will have to reinvest into lower-yielding cash vehicles, “versus a utility dividend that is growing over time,” says Bobby Edemeka, a PGIM Jennison UtilityPRUAX +0.85% fund (PRUAX) portfolio manager.
Jay Hatfield, who runs the actively managed InfraCap Equity IncomeICAP +0.97% exchange-traded fund (ICAP), says he recently increased his utility allocation by a few percentage points, to 15%. “We don’t know what the next trend is, but it’s reasonable to be cautious until the banking crisis is resolved and/or the Fed goes on hold” with rate hikes, he says.
The fund’s holdings include Duke Energy (DUK), which yields 4.2%; Southern Co. (SO), at 3.9%; and Dominion Energy (D), at 4.8%.
Edemeka says that electric utilities have strong tailwinds, such as a growing emphasis on clean energy. They are also investing capital to upgrade their portions of the grid for transmitting and distributing power for things like electric vehicles, allowing them to charge higher rates to recoup capital expenditures. “They are well positioned to sustain consistent earnings and dividend growth,” he says, adding that he expects annual dividend increases of 5% across the U.S. electric utilities spectrum.
One of the fund’s holdings is CenterPoint Energy (CNP), a Houston-based utility that is investing heavily to upgrade its Texas grid, partly because of some bad storms. Analysts expect CenterPoint to earn $1.49 a share this year, up from $1.38 in 2022, and $1.62 in 2024. The stock yields 2.6%. Last year, the company’s dividend payout ratio—the percentage of profits it dispenses to shareholders—was about 50%, below the peer average of 65%, according to Edemeka. That should give it enough room to keep boosting its dividend at a 7%-to-8% annual clip.
Another holding is Ameren (AEE), based in St. Louis and yielding 2.9%. The company is investing in its transmission and distribution grid, and it’s shifting power from some coal plants to renewable sources. All of that should support 6%-to-8% earnings growth, says Edemeka. The company’s payout ratio last year was a little below 60%, leaving upside for the dividend.
SoFi’s Young likes the setup for the sector overall. “Utilities feel like a better place to build that defensive exposure if you don’t have it,” she says.