Are you considering an investment in utility stocks? Utility stocks were once considered investments for “widows and orphans” because they provided a safe, steady, and growing dividend income with good prospects for capital appreciation.
For decades utilities were considered solid investments that held-up well even during recessions. Electricity and water utilities are sometimes even considered recession proof — In a recession you’ll still always find a way to pay the power bill.
Utility stocks are also natural monopolies (there is one set of wires and one set of water pipes going into your home). As such, most utilities are regulated to protect consumers against the predatory monopolists.
Regulation works-out OK for investors because regulators allow utility companies to make reasonable profits and increase prices only when it make sense to do so (inflation, higher fuel costs, etc).
Basically this is all shorthand for a decent but unglamorous stock investment.
That was the past — what about today? Do utility stocks or utility index funds have a place in modern portfolios?
You’ve probably head the phrase “past performance does not predict future results” before. This idea is very important to remember when investing in utilities.
If we look at historical utility performance using available data, we can see that over the long term electric utilities did decently when compared to market averages.
From 1922 to 2001, electric utilities earned an average annual return of 11.2% compared to a 11.6% return for the total stock market. That’s pretty good for a highly regulated business!
If we put on our blinders and look only at the utility sector in the last decade, the relative performance of electrical utilities stands out in a negative manner:
Ouch! Utilities only earned 32% where the S&P 500 earned 85%. That’s some serious underperformance. Why exactly have utility stocks performed so poorly in recent years?
Looking back at the 20th century, utility stocks seem like a smart investment. Not only was America’s population growing at a steady clip, but power usage per capita was also growing.
People began using more and more electricity every day to live a modern life comfortable. What started out as electric lights in a few wealthy Manhattan homes, eventually spread to electrical appliances (and lighting) in every U.S. home.
Electric washing machines, ovens, kitchen appliances, televisions, and even clothes dryers pushed per capita power usage MUCH higher over the last century.
These days we have the internet, wireless routers, big screen smart TV’s, laptops, smartphones, intelligent thermostats, video games, and even virtual assistants like Siri, Alexa, and Cortana…
As you might expect, growing electricity usage helped fuel the electric utility profits. Dividends at utilities rose for decades along with stock prices.
Then, all the happy-magic of expanding per capita electricity usage ended in the year 2010. Since 2010, residential per capita energy usage in the United States has declined.
Growing revenue faster than inflation has become a difficult task for utility stocks. Likewise, expanding dividend growth is also a challenge.
As a result, utility stocks (and utility ETFs) have lagged behind the return of the S&P 500.
Why did the world change from continuously expanding energy usage to one in decline? It’s not like we gave up all our electrical devices!
There are many theories out there as to why this happened. Here’s a few of the more interesting ones I’ve read:
- Conventional light sources have been replaced by LED light bulbs.
- Low power smartphones and tablets have replaced high power desktop computers.
- Smaller transistor sizes led to reduced power requirements for most electrical appliances.
- Consumers became conscious of their environmental impact, and made changes toward electrical conservation.
- Better insulation and more energy efficient heating/cooling made our homes more efficient.
- Warmer weather due to climate change has created fewer heating and cooling days.
- Federally mandated efficiency incentives have led consumers to replace older appliances with more efficient ones.
While no single theory can completely explain the shift, the facts are quite clear — falling per capita residential electricity has affected the returns of utility stocks.
Mostly what we’ve been talking about so far in this post is residential energy usage. That’s the power you use in your home. It accounts for 37% of all electricity generation — but what about Commercial or Industrial use? According to the U.S. Energy Information Administration, commercial electricity growth averaged 1.1% from 2000 to 2015, and Industrial usage grew a mere 0.7% during that same time period.
Those are hardly confidence inspiring numbers!
As you can probably tell by now, I’m not extolling the virtues of utility businesses. I believe they have poor future prospects — Either as an index fund, ETF, or as a basket of individual stocks. Good performance is probably in the past.
To make a broad generalization, utility stocks have high capital requirements, low returns on capital and few opportunities for earnings growth beyond inflation.
These ingredients are not a recipe for incredible stock market success. That said, some individual utilities with unique strategies like NextEra Energy (Symbol: NEE) have been able to outperform. But utility stocks like NEE are the exception and not the rule.
As a group, utility stocks hold very little that interest me. While there are low cost funds that invest in utilities — like the Vanguard Utility ETF (VPU) or iShares U.S. Utilities ETF (IDU), they all have underperformed.
The poor prospects for future compounding make utilities unlikely to keep-up with a low cost S&P 500 index funds like VFINX.
Most investors would be wise to avoid the historical advice associated with investing in utilities. The world has changed (probably for the better), and utilities are no longer growing like they used to.
Now, a simple investment into a stock market index fund can provide enough growth, safety and dividend income to completely replace the utility stock’s place in a modern portfolio.
Even for widows and orphans.