Famous for their high payouts and defensive posture, utilities stocks are widely considered to be a cornerstone of a well-diversified portfolio. With a market cap of $1.23 trillion, the utilities sector offers unique advantages for dividend investors.
The following article provides a high-level breakdown of the utilities sector, its composition and its dividend-earning potential.
Composition of the Utilities Sector
Utilities is one of the 11 primary sectors captured by the S&P 500 Index. It is also one of the smallest in terms of market capitalization. Only real estate has a smaller overall market value. Five industries comprise the S&P 500’s utilities index. They include:
- Electric utilities
- Gas utilities
- Independent power and renewable electricity producers
- Water utilities
Despite their relatively small size, utilities play a critical role in the economy and stock market. Companies that generate or distribute energy resources are responsible for heating homes, providing transportation and powering cities. Unlike other sectors, utilities are usually given monopolistic authority in their region, which means they are essential services with low elasticity of demand. For value investors, this means demand for utility sources – be they water, electricity or gas – remains steady regardless of the economy or market cycle. After all, a recession does not lower consumer demand for electricity.
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While Dividend.com employs a similar breakdown of utilities as the one used by the S&P 500, there are some important differences. These differences better reflect the selection criteria of dividend investors who are considering investing in the sector.
Below is a breakdown of the utilities sector by industry, company count and dividend yield according to Dividend.com:
|Industry||Company Count*||Industry Dividend Yield*|
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The average dividend yield for utilities as a whole is 2.54%, based on latest available data obtained Oct. 30, 2018. For dividend investors, utilities are the second-highest-yielding sector behind financials.
High yields are one of the biggest advantages of investing in utilities companies. Utility providers have high yields because of the artificial barriers placed on energy markets. In other words, utilities companies are protected by the government, which means they face low competition and are unlikely to be affected by broader market forces. Utilities is the only sector that is regulated as a “legal monopoly,” giving it a distinct advantage over other sectors that are more prone to competition.
As such, utilities companies are less volatile, more predictable and highly conducive to defensive portfolios and risk-averse investors. Utilities with the safest dividends include American Electric Power (AEP ), Consolidated Edison Inc. (ED ) and CenterPoint Energy Inc. (CNP ).
Utility industry fundamentals are likely to remain healthy and supportive of future dividend growth, which gives investors a reasonable hedge against rising interest rates. Historically, stock prices and rates have moved in an inverse fashion, which puts most sectors at risk of pullback as the Federal Reserve continues to normalize monetary policy. Within the utilities sector, companies are emphasizing infrastructure and environmental investments – a trend that is expected to intensify as the demand for renewable energy and infrastructure upgrades continues to grow. This is good for investors because utility providers get paid based on their “rate base,” which means the more they spend, the more they earn.
However, the sector’s higher yield doesn’t come free. A lack of volatility in utilities stocks is a double-edged sword as share prices are unlikely to enjoy capital gains. Despite being a protected industry, utilities are not insured by the Federal Deposit Insurance Corporation (FDIC), which means investors have little recourse if an energy provider goes bankrupt. The seismic shift toward renewable energy could also undercut traditional energy providers in the not-too-distant future.
High yields are also no guarantee that dividends won’t be lowered in the future. Utility providers have been known to reduce their dividends, especially after bear market cycles. At the same time, the sector offers no guarantee of protection during major recessions. Case in point: utilities stocks shed 29% in 2008.
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The Bottom Line
Although not nearly as exciting as information technology, consumer discretionary or the recently created communications services sector, utilities play an important role in the economy. For income investors, the sector is a boon to long-term income growth and stability.
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