When a stock sector crushes the S&P 500 index by 15 percentage points over a full year, it’s normally cause for euphoria. But utilities, which are both regulated and sensitive to interest rates, are not your typical industry. And that massive 15-point outperformance translates to just a 1.5 percent total return over the past 12 months.
Now the category confronts several perils. If you are a longtime utility investor, there’s no urgency to quit, particularly if you enjoy a fine dividend yield on the original or average cost. The group’s 10-year annualized total return of 11 percent is excellent. But the bright lights are flickering.
For starters, on fundamental stock market measurements such as price to earnings, utility shares have become expensive. Next, their average 3.7 percent dividend yield, which has not changed much over the years, is a percentage point less than the yield of risk-free Treasury bills.
One possible competitive reaction—hefty dividend boosts—is unlikely because utilities on average are paying out a historically lofty 70 percent of earnings; 60 percent to 65 percent is usual. And the rich mergers and acquisitions that leveraged capital growth and led to higher valuations in the 2010s have slowed dramatically. Precious few takeover targets remain.
In early October, the Dow Jones utility average plunged 21 percent in two weeks, a rout with only a couple of precedents. Utility shares used to be a refuge from all-hands sell-offs, and they were for much of 2022. But looking ahead, if a recession or investor discomfort produces another sharp stock-market downturn in 2023, utilities are likely to suffer in full. The chance that slower economic growth will depress industrial power sales and cap utility earnings is legitimate.
“There’s a reset of expectations,” says Jay Rhame, CEO of Reaves Asset Management, which runs several utility funds. Over the past five years, the path of Virtus Reaves Utilities, an exchange-traded fund, looked independent of the S&P 500. But over the past 12 months, the fund’s correlation with SPDR S&P 500 Trust, the giant broad-market ETF, leapt from 0.6 to 0.9 (a correlation of 1 means the securities move in lockstep).
The same pattern holds for other utility funds. The best ideas now are in individual core utility stocks, such as American Electric Power (symbol AEP) and Xcel Energy (XEL). These two are less tied to the market and are worth keeping or buying on dips.
The outlook from the sages at several big investment firms are bearish (or worse) until the presumed impending recession passes and the Federal Reserve cuts interest rates.
What about the defense that your electric bill is a necessity along with groceries? Well, it is, and the dividends are secure. But the real earnings-growth potential is in wholesale and industrial power, where the prognosis is weak. Someday we’ll see another run of double-digit utility returns, but 5 percent is realistic now.
(Jeffrey R. Kosnett is a contributing editor at Kiplinger’s Personal Finance magazine. For more on this and similar money topics, visit Kiplinger.com.)
