This Fallen Sector Means Big Opportunity For Income Investors

Nick Lanyi's picture

Wednesday, September 30, 2015 - 12:30pm

by Nick Lanyi

The stock market's recent swoon has created buying opportunities in several sectors, including one sector all income investors should be watching: utility stocks.

Because they are sensitive to movements in short-term interest rates, utility stocks have been subject to a double whammy: not only the correction in the overall U.S. market, but also the hardening consensus that the Federal Reserve Board will raise short-term rates in the coming months. 

Rising interest rates are Kryptonite to utility stocks because as regulated businesses, they tend to reward shareholders with above-average dividend yields -- funded by reliable cash flow from customers -- rather than above-average capital gains. When interest rates rise, bonds and other fixed-income investments become more attractive relative to utility stocks. In addition, rising interest rates mean higher costs of capital for utilities, which need to make significant capital expenditures in their own infrastructure (e.g., new power plants).

Fed Chair Janet Yellen has stated several times that interest rates are likely to rise this year -- a stance she confirmed as recently as last week. Why, then, is this a good time to pick up shares of high-quality utilities? I see two reasons.

Rate Fears Have Already Discounted These Stocks -- And Raised Their Yields
First, Yellen is known as a Fed "dove," meaning she prioritizes lower unemployment over reining in inflation. With inflation thus far nonexistent (especially with energy prices in the doldrums), and a presidential election coming up, there's no reason to think the Yellen Fed will raise rates aggressively. On the contrary, thoughtful observers predict a single rate hike by the end of 2015 with periodic hikes next year if the economy picks up steam.

With that outlook, it's highly unlikely that utility stocks will face stiff competition from fixed-income investments any time soon. Even if short-term rates rise 75 basis points (0.75 percentage points) over the next year, 10-year Treasury bonds would still yield less than 3%, well below the average yield of 3.75% for the Dow Jones Utility Index. 

In addition, I believe the correction we've seen in utility stocks this year -- the Dow Jones Utility Index is down 14% from its 12-month high on Jan. 29, 2015 -- already takes this risk into account and then some. On the day the Fed raises rates, utilities will take it on the chin. But I don't see a great deal of downside risk for the best utility stocks from this level.

Utilities Are The Backbone Of A Diversified Portfolio
The second reason this is a good time to pick up shares of topnotch utility stocks is simple: they play an important role in a diversified portfolio and should always be on your buy list if you don't already own them in bulk. Electric utilities provide an essential product -- name one that's more fundamental! -- while providing investors with reliable income at a time when it's in short supply anywhere else. Just as important, that income rises steadily over time, rewarding buy-and-hold investors with high and rising yields on their original investment.

Take Southern Company (NYSE: SO), one of my favorite utility stocks. Had you bought shares at the open on the first day of trading in 2005, you would have paid $33.21 a share; that year, you would have received $1.475 per share in dividends for a yield of 4.4%. The total dividend this year is expected to be $2.15, for a yield of 6.5% on the original investment. As time goes on, the dividends rise steadily, and so does your yield.

When selecting individual utility stocks to own, I stick with large utilities with diversified energy sources and plenty of southern exposure. One source of risk in owning these stocks comes from regulators, who control utility rates and capital investment plans -- not to mention environmental regulations, which pose risk to coal-heavy utilities in the coming years as states implement the U.S. Environmental Protection Agency's new emissions rules. In general, southern states tend to be friendlier to utilities -- and the net positive population growth in Sun Belt states generates economic growth that keeps demand rising.

Southern Company is one of the nation's largest electricity providers, with regulated utility operations in Georgia, Alabama, Mississippi and northwest Florida; a power-generation portfolio that includes three nuclear plants; and various telecom operations.

The company recently announced the $12 billion acquisition of AGL Resources, an Atlanta-based natural gas utility with 4.5 million customers along the East Coast. While some analysts questioned the amount Southern is paying, the company can well afford it. Strategically, it shifts Southern from reliance on coal-fired power plants toward affordable, abundant and relatively clean natural gas and provides a steady source of that fuel for its own generators. The deal will make Southern the second-largest utility company in the United States.

Southern Company's stock currently yields a healthy 4.9%; the company has increased its dividend every year since 2003 and has a payout ratio of 90%, indicating further room for regular growth. The stock is down 16.5% from its 52-week high and trades at only 15.4 times estimated earnings for 2015.

Another favorite of mine is Dominion Resources (NYSE: D), which operates both electric utilities in Virginia and North Carolina and also has extensive natural-gas utility, distribution and storage operations in those states, Ohio and West Virginia. The company has a long-standing reputation for managerial excellence and is well positioned to benefit from expanded use of natural gas in the years to come, both from power generation and liquefied natural gas (LNG) exports (Dominion has broken ground on its Cove Point export facility in Maryland).

Dominion's stock currently trades 14.2% below its 52-week high and yields 3.7%. The company has raised the dividend every year since 2004 and has a payout ratio of 85%, indicating room for further dividend increases. At current levels, the stock trades at a reasonable 18.8 times analysts' consensus earnings estimate for 2015.

Risks To Consider: Utilities may continue to fall as investor fears over a looming rate hike continue. Also, changes in energy regulation or increasing raw material prices can hurt utility cash flows.

Action To Take: Evaluate your portfolio diversification and consider adding a utility stock or two. Although utilities are unloved in today's market, locking in a low buy price will help juice your capital gains and dividend yields in the future. Southern Company (NYSE: SO) and Dominion Resources (NYSE: D) are a good place to start your search.

Editor's Note: Recently, High-Yield Investing's Nathan Slaughter uncovered eight elite stocks that returned more than 300% on average in the past decade; more than 3 times the S&P's total return. But the best news -- their upside is only just beginning. Get the names of each of these stocks by accessing the new report here.

Nick Lanyi 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.