Yahoo Finance Generate Income and Play Defense With Utility Stocks
Did the January market volatility shake you up? If stock market roller-coaster rides make you queasy, there are sectors that historically offer investors a little more stability.
The utilities sector, which includes electric, gas and water companies, traditionally offers investors a solid income stream through steady dividend payments, but it also tends to outperform Wall Street on a relative basis during down markets.
There is a case to be made for beefing up exposure to utilities in the current market environment. "The utility sector has clearly shown its defensive nature by outperforming the [Standard & Poor's 500 index] quite handily so far this year. With slowing economic growth, recessionary fears rising, Fed interest rate hikes likely to be delayed and continued commodity weakness, this is a recipe to own or continue to own utility and consumer staples in one's portfolio," says Jeff Carbone, managing partner at Cornerstone Financial in Charlotte, North Carolina.
Momentum-chasing investors may consider utilities a little boring. But they can offer more stability for the defensive-minded investor. "Utilities generally have a more stable business model than the average S&P 500 stock, suggesting a lower risk/reward profile. If the overall economy slows, utilities may outperform since they benefit from more stable volumes," says Mike Bailey, director of research for FBB Capital Partners in Bethesda, Maryland.
No matter the economic cycle, consumers still turn on their lights and take showers, which also lends stability to utility company business models. "Utilities are the bedrock of the corporate landscape. Everyone is a customer," says Hilary Kramer, editor of the GameChangers stock newsletter.
"Just about every phase of the economic cycle relies on water, fuel and power on demand. This means that the companies that provide these economies generally generate plenty of cash flow, and since most of the heavy infrastructure has already been built, there's rarely a reason to spend a lot of that money on expensive capital programs. As a result, most utilities can pass on higher-than-normal rewards back to shareholders in the form of dividends," Kramer says.
Defensive sectors can post declines as well, but they are generally not as bleak as the broader market. "When the broad market stumbles, utilities bleed, too. However, the extent of the losses is usually substantially lower. In the 2007-09 bear market, utilities fell 13 percentage points less than the S&P 500. It still hurt, but the pain was less intense," Kramer says.
Now may be the time to consider diversifying a portion of your portfolio into the relative safety of utilities. "Investors looking to move up the quality curve amid the current market fluctuations could take a look at utilities as one way to potentially reduce portfolio volatility while earning yields above the market average," Bailey says.
The first step is to figure out how much of your portfolio you want to allocate to the sector. "Young investors looking for long-term growth might end up with only 3 to 5 percent weighting here, while retirees who want to ensure current income could easily go in for 10 percent or more," Kramer says.
Here is a look at five ways to gain exposure to the utilities sector:
NextEra Energy (NEE). Bailey says NextEra, a renewables-heavy utility, is an attractive play based on earnings and dividend growth. "NextEra has a good track record of meeting or beating Wall Street estimates, and future earnings projections continue to creep higher. If the company continues to exceed expectations, then the current valuation suggests you are buying an above-average utility for an average price," Bailey says.
Sempra Energy (SRE). Although this company is working to resolve a methane leak at a California gas well, Bailey believes current prices do not reflect the company's long-term transformation, diversification and growth, which he says is nearly double the industry average. "We believe that over the next three to five years, investors may begin to fully value Sempra's transition from a regional electric utility into a multinational energy company that's expanding into natural gas, pipelines, liquefied natural gas and renewable energy," Bailey says.
Exelon Corp. (EXC). Exelon is the holding company for Chicago-based Com Ed, Philadelphia-based PECO and Baltimore Gas & Electric, and is a leading energy provider in the U.S. Exelon has earned a "strong buy" rating from Christopher Muir, senior industry analyst at S&P Capital IQ. "I think Exelon is well-situated to benefit from the Clean Power Plan, as the company has significant nuclear holdings and is coal-free," Muir says. "We see the acquisition of Pepco Holdings (POM), pending approvals, leading to significant cost savings."
Public Service Enterprise Group (PEG). This energy provider is primarily located in the northeastern and mid-Atlantic states, operating nuclear, coal, gas and renewable facilities. "The stock offers a 4 percent yield right here and plenty of headroom on the chart down here at 11 times trailing earnings," Kramer says. "The company is only paying 42 percent of its free cash flow in dividends now, so we should see the quarterly checks get richer in the future."
Vanguard Utilities Index Fund (VPU). Investors looking for an exchange-traded fund to gain exposure to utilities can consider the VPU, which is the second-largest utilities ETF at $1.7 billion in assets. S&P Capital IQ ranks Vanguard Utilities Index Fund as "overweight," and analysts say it compares favorably to the Utilities Select Sector SPDR (XLU), which only holds S&P 500 stocks. The Vanguard fund also has mid- and small-cap exposure.
The bottom line? "Anyone looking for reliable cash flow at minimal risk should keep utilities on their radar. Retirees appreciate knowing that these stocks pay them regular checks to cover current living expenses. The less comfortable with market risk you are, the more long-term exposure to utilities you should cultivate," Kramer says.
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