3 Ways To Profit From The Best-Performing Sector Of The Year

Tim Begany's picture

Monday, September 22, 2014 - 6:00pm

by Tim Begany

Despite ongoing worry about the risk of a big correction, the market is having quite a good year.

The S&P 500 is up about 10%, and the financial media is packed with reports about high-profile takeovers, major initial public offerings and soaring tech and biotech stocks. So investors may be shocked to hear which sector is leading the pack in 2014 -- and by a sizeable margin.

In fact, the sector is up around 15% year-to-date, placing it more than 4% ahead of the highly-publicized tech sector and even a tad out in front of the red-hot biotech industry. Some other sectors aren't even in the same ballpark as utilities.

This outperformance is a surprise, considering the negative sentiment toward utilities at the start of the year. At that point, many analysts expected the sector to underperform because of a greater risk appetite among equity investors and gradually rising interest rates, which analysts surmised might begin pushing more conservative income-oriented investors back toward bonds.

However, utilities have retained their appeal in 2014 because in many cases their yields still well-exceeded those of government bonds and high-quality corporate debt. What's more, many equity investors sought refuge in the relative safety of utilities during the big tech and biotech pullback of mid-March to early May.

The sector should remain attractive in coming years for similar reasons. Even if the Federal Reserve starts aggressively hiking interest rates, it'll take time for rates to rise enough to lure income seekers away from utilities en masse. Plus, with the odds of a long-overdue correction growing daily, many equity investors will want a sizeable stake in utilities -- these stocks typically fluctuate less than the market but still often have decent total return potential.

For utilities exposure, individual stocks are preferable to mutual funds and exchange-traded funds (ETFs), in my opinion. A big reason: Funds and ETFs often don't do much to blunt risk, since they tend to have substantial exposure to more volatile smaller companies, as well as to the larger, safer ones.

With nearly half its assets in mid- and small-cap stocks, for instance, the Vanguard Utilities ETF (NYSE: VPU) has shown about the same volatility as the market -- pretty typical of the various utilities funds and ETFs I've seen. VPU does currently yield 3.3%, though.

With individual utility stocks, you can pick and choose from among the best and safest to better minimize risk while still getting attractive yields. Here are several to consider:

Besides an excellent yield, this Southeast United States-focused utility has a rock-bottom beta, a metric that compares a stock's price volatility to that of the overall market. In Southern Co.'s case, a beta of 0.03 means it's 97% less volatile than the market. As a point of reference, in the crash of 2008, when the market plunged 37%, shares of Southern Co. were only off 0.2%.

As the dominant player in its region with 4.4 million customers, Southern Co. is a champ at raising dividends -- which it has done 14 years straight. Analysts at Morningstar project the firm's payout will climb 3.5% a year going forward, a reasonable estimate considering it has grown 4% annually for many years.

Although Southern Co. traditionally relied on coal for power generation, it's much more diversified now because of major investments in newer, cleaner, more efficient plants. Currently, coal only accounts for 38% of power output, compared with 42% for natural gas and 16% for nuclear. Southern Co. should also continue to benefit from the Southeast's especially favorable regulatory environment, which is known for consistently supporting solid profitability.

With 7.2 million customers mainly in the Midwest, Duke Energy is the largest U.S. utility. Its dividend was cut during the worst years of the recession -- 2007 and 2008 -- but has since climbed about 3% annually to current levels. With earnings projected to rise at about a 5% pace going forward, 3%-a-year dividend hikes should remain doable.

To facilitate steady growth, Duke, too, has been eschewing coal, just recently announcing, for example, a $500-million investment in several big solar power projects in North Carolina. The firm also recently earmarked $1.5 billion for a proposed natural gas-powered plant in Florida.

Duke has been catching legal flak from environmental groups recently for spilling 39,000 tons of coal ash into the Dan River in Danville, Virginia. The financial impact on Duke is as yet unclear, but the firm is a good bet to avoid a settlement larger than it can comfortably absorb thanks to its close relationship with regulators and the EPA. In any case, such matters tend to drag out, so it could be years before this even becomes an issue for shareholders.

With 6.6 million customers in the Midwest and Mid-Atlantic regions, Exelon's customer base rivals that of Duke. But what really sets Exelon apart is its leadership in nuclear power -- the firm accounts for nearly one-quarter of the nuclear power generated in the United States.

The benefits of this are twofold. First, although expensive to build, nuclear power plants are cheaper to run, making them profitable even during periods of lower energy prices, like now. Second, they have a huge leg up on fossil fuel-fired power plants in profitability when oil and gas prices soar, which they tend to do over time.

Because of some relatively tough price regulation in its service area and large ongoing costs for acquisitions and capital improvements, Exelon has seen its earnings and dividends shrink for roughly the past five years. However, the firm has managed to maintain attractive payouts, and these should soon begin rising gradually again now that earnings growth has resumed and is projected to persist in coming years.

Risks to Consider: Since dividends are typically the main attraction of utilities, these stocks are usually extra sensitive to interest rate hikes -- and we're entering a rising rate environment now. If the Fed decides to increase rates a lot faster than expected, bond yields could pretty quickly climb enough to entice income investors out of utilities, prompting a sharp drop in these stocks.

Action to Take --> Shockingly, utility stocks are at the forefront of the bull market in 2014, and I believe they can continue to perform strongly for at least a couple more years. They're worthy of consideration by equity and income investors alike.

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Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.