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My Favorite Sector for Summer: Utilities

Utilities are the proverbial red-headed stepchild of stock market sectors. During bull markets (so the thinking goes), utilities tend to underperform more aggressive sectors like technology or industrials. But during a good market rout, utilities take a beating along with the rest.

How unloved are utilities?

As I wrote in a recent article, they were by far the most shunned sector by the large money managers interviewed by Barron’s (see chart). Fully 30% of the “big money” managers picked utilities as the worst performer of 2012, and barely 3% thought it would be the best. (On the flip side, more than 30% of the managers chose financials and technology to be the best-performing sectors, and technology had not a single manager who voted it worst).

As a contrarian trade alone, utilities would be interesting. After all, the sector has been known to take investors by surprise; during the 2003-07 bull market, utilities were one of top-performing sectors on a price basis, and this did not include the high and rising dividends enjoyed by investors during the period.

And this brings me to my primary rationale for liking the sector: In a world where 2% is a “good” yield on a 10-year bond, the 3.9% paid by the Select Sector Utilities SPDR (NYSE:XLU) is attractive. It’s roughly double the dividend yield paid by the S&P 500. And unlike the interest paid by a bond, the dividends of XLU constituent companies have a history of rising over time (more on that in a moment).

While portfolio growth is essential to meeting your retirement needs, growth ultimately doesn’t pay the bills; but income does. Yes, you can sell off appreciated shares to meet current expenses, but that doesn’t work particularly well when the market is trading flat or down. Just ask investors who needed to sell their shares during the pits of the 2007-09 bear market and panic.

The problem for most investors is that their traditional sources of stable income — bonds and CDs — simply do not pay enough in this interest rate environment. This means finding a respectable current income often means accepting stock market risk.

Frankly, I’m OK with that. An investor who is comfortable holding a 30-year bond to maturity should be equally comfortable holding a solid dividend-paying stock. If income is your objective, the bends and twists of the stock market can be safely ignored — so long as you are reasonably sure that the dividend is safe.

Let’s take a look at some of XLU’s largest holdings, starting with Southern Company (NYSE:SO). Southern, as its name might imply, serves electricity to much of the Old South. It is a diversified power company that generates electricity through coal, nuclear, oil and gas, and hydroelectric assets.

Southern also is a prolific dividend raiser. The company recently raised its quarterly dividend to 49 cents per share, up from 40.3 cents at the onset of the crisis in 2008 — an increase of more than 21%. That’s not bad, given that many companies were forced to slash their dividends in those volatile years. Southern currently yields 4.3%, which is substantially higher than what you will find in the bond market outside of junk. And whether or not we have a eurozone meltdown, that dividend is unlikely to be affected.

Another of XLU’s holdings worth noting is Duke Energy (NYSE:DUK). Like Southern, Duke is based in the American South. And also like Southern, Duke was able to continue growing its dividend throughout the crisis years of 2008 and 2009 and beyond. Duke currently yields 4.6%.

If we managed to get a breakthrough in the ongoing European debt crisis, I would expect more speculative sectors to outperform. It will be “risk-on” season again, and defensive sectors like utilities will lag behind. But if the European crisis continues to drag on, you can bet investors will flock to conservative income-producing sectors, and utilities could easily be the best-performing sector for the next quarter and beyond.

More from this series:

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”

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