We love utility stocks! Electric, gas, telecom and water stocks have formed a cornerstone of our investment strategy ever since we began 25 years ago.
Why the fondness for utilities? In a word, the magic of dividends. Historically, utility stocks have offered significantly higher dividend yields than most other sectors of the stock market. Generous utility dividends serve us two ways:
- The cash payout provides a steady source of total return. When the stock market seems to be climbing straight up, investors tend to underestimate the value of dividends. However, those little cash payouts can make a tremendous impact on your wealth over time — especially during the (sometimes lengthy) periods when the market is struggling to gain ground. In the 10 years ended December 31, 2014, for example, the S&P Utilities Index, with reinvested dividends, turned an initial $10,000 stake into more than $25,000. Over the same stretch, the same amount invested in the S&P 500 index grew to just $20,900.
- Dividend-rich stocks like utilities cushion your portfolio in a stock market downturn. Over the past decade, according to Morningstar, a basket of electric and gas shares captured about only one-third of the downside when the stock market was falling. That’s not perfect protection, for sure. However, it’s unusual to find a low-volatility asset that also lets you earn a respectable profit. Utilities help you build the emotional stamina to stay in the fight when other investors get knocked out of the ring.
Rush Out and Buy Utility Stocks Now?
With all their positive attributes, you might think I would be urging you to rush out and stuff your portfolio to the gills with utilities. Not so. Not right now, anyway.
Since last summer, utility shares as a group have skyrocketed as plunging Treasury-bond yields sent folks scurrying for income-producing alternatives. At the January 29 peak, the Dow Jones Utility Average had zoomed 24% from its August 2014 low.
Nothing wrong with that, of course — if you bought your utilities at significantly lower prices. At today’s prices, though, the typical utility stock is tossing off a yield of only about 3.5%. Some of the faster-growing companies in the industry, or those perceived to be safest, are yielding 3% or less.
Paradoxically, low yields can make a utility stock unsafe. When bond yields tick up, as they did in the summer of 2013, utility yields generally follow suit — and share prices tumble.
In just five weeks from May 17 to June 20, 2013, the Dow Jones Utility Average dropped 10%. More recently, as Treasuries backpedaled from late January through mid-February, the Dow utility index shed 9%.
Rougher Seas Ahead for Utilities
I’m not predicting a catastrophe for utility stocks. As we get closer to the Federal Reserve’s first rate hike, however, I expect utilities will run into increasingly sharp bouts of selling. Now is the time to have a clear plan for dealing with the rougher weather I see ahead.
Here’s what I suggest:
If you’re relying on your utility stocks for current income to live on, sit tight. As long as you purchased your utilities at or below our recommended prices, you should earn an acceptable return over the long haul (three to five years, and beyond). Remember: Unlike bonds, utility stocks can — and most do — boost their dividends over time. Rising dividends will tend to bolster the share price, counteracting the undertow from rising bond yields in years to come.
If you’re not yet retired but are holding utilities in a retirement account, do some tactical trading. For this purpose, I advise watching the price of the Utilities SPDR (ETF) (NYSEARCA:XLU), an exchange-traded fund that owns all the electric and gas utilities in the S&P 500 index.
Should XLU rebound up to the area of its January intraday high ($49.78), you might sell any utilities in your retirement account, with the intent of buying back during the May to August time window. While the February pullback improved values somewhat, I think XLU will eventually slip 12% – 15% from the January peak before the next across-the-board buying opportunity arises.
What if you’re not retired but you’re holding utilities in a taxable account? In that case, before selling, you must weigh the cost of any capital gains tax you would owe. Can you offset the gain with a loss elsewhere in your portfolio? If you can, you might apply the trading tactic I suggested in the previous paragraph.
Look to buy utilities whose share prices take an abnormally large, unjustified tumble. We have promoted gas distributorAGL Resources Inc. (NYSE:GAS) — the parent of Atlanta Gas Light and Chicago-based Nicor Inc. — from a “hold” to a “buy.”
Why the upgrade? GAS came in with a slightly disappointing Q4 earnings report, unleashing a flood of sell orders from Wall Street’s jumpy minions. GAS stock dove almost 14% from its January high — a big move in a short span for a utility.
Even more excessive, the plunge occurred just as the company was raising its five-year target for long-term earnings growth to 6% – 9% annually. If management can deliver on this projection, AGL Resources may prove to be one of the utility industry’s star performers over the next few years.
Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Specialized Information Publishers Foundation.
