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Buying Into High Barrier-to-Entry Utility Companies

SPDR XLU is a great way to bet on the utility sector


After soaring to $298.73 last summer, shares of Netflix (NASDAQ:NFLX) have plunged almost 75%. What’s with the cratering share price? Investors have apparently awoken to the sobering reality that Netflix operates in an industry with almost no barriers to entry.

The company owns none of the content it sells, nor does it own the transmission lines required to deliver its content. It is a virtual movie store. Anybody with enough capital and motivation can easily replicate the business. And ventures such as Hulu, HBO GO, and Xfinity, among others, have done just that—and they are taking market share. I have long eschewed low barrier to entry businesses—especially those like Netflix that lack tangible assets. I much prefer stable companies that operate in businesses with high barriers to entry for you. Even better are monopolies that earn guaranteed returns based on contracts with local regulators.

I am talking about utilities. With regulatory contracts in-hand, most utilities are the only game in town. In return for monopoly status, they earn guaranteed returns and have revenues that increase with inflation. If they fall behind the eight ball, they simply file with the local regulator to increase their rates. With high yields and a built-in inflation protection tool (filing for higher rates), utilities are low-risk income generators.

With all of this in mind, I am suggesting a strategy for wise investors that includes utility funds and stocks.

The fund I am recommending for you is the Utilities Select Sector SPDR Fund (NYSE:XLU) is an ETF that owns utilities. The fund invests in a portfolio of gas, electric, and mixed utilities, with holdings that include Duke Energy (NSYE:DUK), Exelon (NYSE:EXC), and NextEra Energy (NYSE:NEE). XLU also owns some of America’s largest utilities, like Southern Company (NYSE:SO), Dominion (NYSE:D), and Consolidated Edison (NYSE:ED).

Southern Company is one of America’s largest electricity generators, operating 42,000 megawatts of generating capacity. At over 100 years old, Southern Company supplies regulated retail electricity service to 4.4 million customers in four states. Alongside its regulated operations, Southern Company owns a competitive wholesale power generation business named Southern Power. The wholesale unit has a generation capacity of 7,700 megawatts and serves 75 customers throughout the southeast. Southern Company yields 4.3%.

Dominion is perhaps one of America’s oldest surviving companies. Its roots date back to 1787 when a predecessor company, Appomattox Trustees, was created to promote navigation of the Appomattox River. The company’s foray into electricity began in 1888 when it took control of hydroelectric stations on the river.

Today, Dominion is a leading electricity producer, operating 28,200 megawatts of generation capacity. The company also operates 11,000 miles of natural gas pipeline and the nation’s largest natural gas storage system. The storage system can hold 947 billion cubic feet of natural gas and serves 15 states. You can see on the chart below that there is a rising trend of gas storage in the United States. Companies that own storage facilities are quickly maxing out their capacity.

In 1823 in Manhattan, the New York Gas Light Company received a charter from New York State to provide downtown Manhattan with natural gas for lighting. Part of the company’s business was replacing whale oil lamps that had been installed in the 1760s. In 1880, after pioneering the lightbulb with financial backing from J. P. Morgan and the Vanderbilts, “the Wizard of Menlo Park,” Thomas Edison, founded the Edison Electric Illuminating Company of New York to monetize his invention.

The two companies would eventually merge, and today the combined company operates an energy delivery network that supplies electricity to almost all of New York City and Westchester County, and gas to the boroughs of Manhattan, the Bronx, Queens, and to Westchester County.

Centuries of Staying Power

Notice that all three companies I have highlighted above are over 100 years old. That’s no accident. Utilities operate monopoly businesses with high startup costs and government protection. The barriers to entry are nearly insurmountable.

XLU yields around 4%. You can see on my chart that the Utilities Select Sector SPDR ETF has been in a steady uptrend since the 2008 bear market. Buy the fund, gain exposure to the well protected utilities sector, and pay a low expense ratio of only 0.18%.

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