Utility Stocks: Treasure Or Trash?
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?
Historical Performance
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?
What Changed
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.
The Theories
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!
Final Thoughts
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.
Very interesting article. Also, these stocks have to a large extent notched some very nice gains over the past decade or so given their steady high dividend payouts combined with the low interest rate environment. But with interest rates on the rise, bonds are becoming more competitive. This will likely create some significant headwinds for utility stocks.
Interest rates indeed have an impact on the performance of these stocks. Because revenue growth is so low, it’s reasonable to think of them as exactly like bonds and should be compared to them.
There might be a few exceptions like NEE, but for the most part I think utilities will struggle.
That’s good to know. I have never even considered utility stocks or thought about them. I guess tech stocks are all the hype these days. But with anything, technology changes so fast, so we can’t even be sure Iphone will be popular 10 years from now (at least I’m not).
It’s true, but in 10 years it’s very likely you’ll still be using electricity. Tech stocks do indeed get all the press.
Thanks for your thoughts (as always) Ms. FAF!
Oh I just got a better idea of what my father in laws job was before he retired…
He use to work for pg&e as a regulatory specialist. It said it on his business card. He had to go talk to everyone and wiggle himself through to get his work done. That was his work! That and court. I always thought he was an engineer like he studied to be, but that sounds more like a politician??
After the northern California fires, pg&e said they would no longer offer dividends to pay for the damage. The stock tipped a lot and it looked like a good buy but yes you’re right, it doesn’t seem like a very bright future for utilities. Electricity is only one!
Yep, you could think of a regulatory specialist as a lot like a politician. Utilities want to raise prices, but of course it’s not that easy… price increases have to be justified.
Even the best performing utility that I’m aware of (NEE) is only allowed a 10% ROE by it’s regulatory organization. The average S&P 500 company earns about a 14% ROE.
The difference in performance over the long term should be pretty clear.
Nice analysis, Mr Tako.
I’d look for a utility as a heavy dividend payer if in the portfolio if the balance sheet is not over stressed and the valuation is attractive. If one can get a 6% yield with 2% dividend year on year growth then a forward 8% return isn’t terrible but it isn’t going to be your best returning investment either.
The upside could be a multiple expansion and thus an unrealized capital gain should interest rates drop again (I suspect it may well happen). Somewhat like some of the better REIT valuations that exists now and over recent weeks.
That being said, I haven’t picked up other utilities but did buy some Altria (MO) a few weeks ago when the price was in the low 60’s. A high yielded with a greater rate of dividend growth. Now I need to wait for my cash balance to recover.
Happy investing!
-Mike
You’ll probably do great with MO. Unfortunately, utilities that yield 6% are hard to find! 😉
I consider Utilities as an income play from a portfolio strategy perspective. My growth expectation is therefore lower.
Yep, I understand that some people favor certain investments for income and “safety”.
The reality is that utilities are incredibly vulnerable. Most have cut dividends at one time or another. The most recent to do so is PG&E: https://www.barrons.com/articles/as-bad-as-it-gets-pg-e-cuts-dividend-tumbles-16-1513878628
In my opinion, the risk premium isn’t there.
Interesting, the utilities I invest in are Canadians and no dividend cut has happened in a long time. The big ones are Fortis and Emera and then there is BIP. There probably is a difference between the CAD and US utilities I am not aware of.
Cheers.
How about the potential of an more electrified transport economy? Referring to electric vehicles here obviously. Our hunger for energy is far from over, but our energy efficiency is improving, hard to say where this is doing in the coming years. But my guess is still up, however, I hear your concerns.
Also the transition to more renewable energy sources (which are slightly more expensive, albeit trending down very rapidly) will have a short term negative effect I imagine.
You’d think the growing number of electric cars would drive up energy use, but the data seems to show that’s not the case. How long that lasts, I don’t know… but it’s a very interesting question nonetheless.
As far as renewable energy goes, the utility I pointed out as being a top performing (NEE) is huge into renewable energy generation. It might cost a little more, but the federal incentives put in place are more than making up for it. While this is only a sample size of one, performance seems to indicated renewables are not a factor in utility stock performance.
Really interesting blog post! Thanks. I didn’t know energy consumption per capita was decreasing in the states, I was thinking it was still increasing. This is great, even if the decrease is not huge. It may not be great for some of the companies, but will be great for new companies focusing on more green and renewable energy.
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Most utilities in the U.S. are shifting their power generation to renewables quite quickly. In my own State, a huge chunk of power generation is from renewable sources (over 75%, mainly from wind and hydro).
The U.S. is rapidly shifting to renewable sources. At the same time as there’s an excess of natural gas, oil, and coal.
Another thing to note – the utility companies (specifically electric and gas) are also now giving out large new construction grants to induce builders to reduce their base level of energy use in buildings. They do this to extend the life of existing power stations etc because they cost so much to replace/expand. For a comparison, a new sewer treatment plant near us cost $1 billion to build.
Interesting. I’d love to read more about this. Can you link me to some data?
About the grants, or the cost of new systems? Here’s the plant I’m referencing: https://www.seattletimes.com/seattle-news/king-countys-brightwater-sewage-treatment-plant-costs-mount/
Really basic info on grants: https://pse.com/savingsandenergycenter/ForBusinesses/Pages/Commercial-Custom-Grants-for-New-Construction.aspx
I researched some utilities a while ago. It did look like a lot of the payers in the DJ Utilities Index ended up cutting dividends every couple of decades or so.
I also believe since the index was started in 1929, the whole return was due to dividends ( granted, utilities were in a bubble in 1929)
That being said, being a regulated monopoly can provide satisfactory returns.. provided you bought at a decent entry price…
It’s interesting, not long ago Buffett bought into the utility business. For years utilities haven’t been a great investment and he was probably well aware of this.
Compared to the things he usually invests in, the returns are middling. Perhaps he got it at a really good price?
Great post and very good point that we’re in a new epoch. I’ve always been leery of investments with a firm cap on the upside, and investing in utilities nowadays feels like picking up nickels in front of a steamroller. Some of them may end up pretty good investments, but I’m at a loss to pick which ones.
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I’ve been really happy with my utility stock, it is Fortis (FTS) and it has paid out a dividend for a long time. I’ve owned it for years- at least over 8 but I can’t recall. I also recently bought MO (Altria) and that’s not a utility but as mentioned above, it has a great dividend!
a few months ago i researched some clean energy solar and wind stocks. depending on who’s in charge in government they could have a guaranteed rate where the utilities are mandated to buy their clean power. the ones on my list are PEGI, TERP, and BEP. i’m waiting on all 3 and just watching the list but of the 3 BEP shows the most promise to me. brookfield has some knowledge on how to run a utility and they are expected to turn a profit this coming year.
I like DUK & D as good names due to fact that their customer bases are growing much faster than average, and both are investing heavily in renewable energy, especially D. D also has a nascent but growing business in NGL, as well as pipelines and storage. Both have a heavy interest in the Atlantic Coast Pipeline that’s close to completion as well.
Overall I agree, most utes aren’t likely going to be stars but the few that do, provide reliable dividend streams and provide very good returns if bought on the cheap. D has been oversold over their proposed buyout of SCANA and the associated political quagmire in the SC legislature. Rising interest rates have also been a headwind for most but not all utes.