Inflation is a risk, but utilities can do well if regulators let them raise rates enough.
Over the three months preceding May 4, utilities were the second-best-performing sector in the S&P 500, rising more than 3% as the broader market fell about 7%. Investors are moving into these stocks as a defensive play amid worries about the economy. That leaves about three-fourths of U.S utilities overpriced, according to research firm Morningstar, even as higher inflation is poised to threaten profits. “The risk for utility stock investors is fairly high right now, and the investment options are limited,” says Don Kaufman, co-founder of trading education firm TheoTrade. “That being said, the potential for the sector to outperform the market makes it a place to consider investing.” As of May 3, all but one of these stocks were yielding more than the 10-year Treasury note. But dividends aren’t everything, and sometimes it may be wise to pick a utility with a lower payout if it’s a stronger company. Here’s a look at six utilities stocks to put on your watch list.
American Electric Power Co. Inc. (ticker: AEP)
Because investors often buy utilities for their dividends, the Federal Reserve’s plan to raise interest rates as it combats inflation may dim their attractiveness compared with bonds. Those higher rates also make it more costly for utilities to borrow money. Still, although inflation can make utilities’ costs jump more than their revenue, the sector can perform well during times of inflation if regulators allow firms to raise rates enough to pass higher operating costs on to consumers. Credit Suisse Group AG (CS) said in a note in late April that large-cap multistate utilities that are replacing fossil fuel generation with renewable energy are best positioned amid inflation. One of its top picks is AEP. “We believe investors should be focusing on AEP’s strategic pivot of divesting under-earning, low-multiple assets … to fund the company’s coal replacement strategies with regulated renewables, paired with a growing transmission rate base,” Credit Suisse said.
Dividend yield: 3.2%
Duke Energy Corp. (DUK)
Robert Johnson, finance professor with Creighton University, agrees with Credit Suisse that utilities can perform well in inflationary times. From 1966 through 2020, the S&P 500 returned 6.2% during periods when the Fed was hiking rates, but utilities were one of the best-performing sectors in that rising-rate environment, gaining 8.4%, he says. “The bottom line is that historically, utilities have been one of the best-performing sectors in a restrictive monetary policy environment.” He adds, “Investors would likely be well served by increasing their exposure to the utility sector as the Fed continues to raise rates in order to fight inflation.” According to the Credit Suisse note, Duke Energy is well positioned in the inflationary environment, as its size and footprint may give it an advantage over its peers. Another edge for Duke is its decarbonization effort, as it works toward retiring its coal portfolio.
Dividend yield: 3.6%
Consolidated Edison Inc. (ED)
Kunal Sawhney, CEO of Kalkine Group, also points to large-cap stocks as likely sound investments amid inflation and interest rate anxiety as well as continuing effects of the COVID-19 pandemic, the war in Ukraine and the recent slide in mega-cap market leader Tesla Inc. (TSLA). He points to Consolidated Edison as a large-cap, dividend-paying utility stock to watch. “These companies generally come with market dominance and the likely potential for business continuity in the face of supply chain disruptions,” he says. “Large-cap players are also known for solid dividend-paying records, which means that investors can have dividend income in case volatility doesn’t allow high capital gains.” Consolidated Edison has increased dividends for 46 years in a row.
Dividend yield: 3.4%
Pinnacle West Capital Corp. (PNW)
Utilities can be tough to value based on fundamental analysis, says Kaufman. “However, since the focus of owning these companies is for the dividend, it does make it easy to boil it down to a couple of metrics like price-book and the relative dividend yield,” he says. “Using the P/B allows you to compare the price of the stock against the book value or equity in the company on a per-share basis.” A disappointing outlook from Pinnacle has pressured its shares and resulted in a price-book ratio below its 10-year median and a dividend yield that is above its 10-year median, Kaufman says.
Dividend yield: 4.7%
UGI Corp. (UGI)
Another utility stock that may provide a good combination of yield and valuation is UGI, a Pennsylvania-based energy distribution and services company, Kaufman says. With a decline in first-quarter earnings because of warmer winter weather and commodity volatility, the company has underperformed its peers, he says. Analysts are estimating earnings will bottom out this year and increase in 2023, he says. UGI’s dividend yield is well above its 10-year median, reflecting low price-book value, he says. Last month, the company acquired a 33% equity interest in Ag-Grid Energy, which develops and operates small-scale renewable power projects.
Dividend yield: 4%
NextEra Energy Inc. (NEE)
Investors often turn to utilities for stability in times of economic uncertainty. After all, homes are going to need power regardless of what the economy is doing. As the world’s biggest renewable energy company, NextEra’s size and diverse holdings lend stability to the company but also make the stock lower-yielding. “The combination of revenue growth and projected [earnings per share growth] makes this company one that should be considered,” Kaufman says. “Also, the major industrial growth that is happening in the state of Florida is a major plus.” Although its price-book ratio is similar to its peers and its yield lower, “the more growth-oriented outlook of the company may mean that its valuation improves through increased future earnings,” Kaufman says.
Dividend yield: 2.2%
These six utility stocks offer dividends plus return potential:
— American Electric Power Co. Inc. (AEP)
— Duke Energy Corp. (DUK)
— Consolidated Edison Inc. (ED)
— Pinnacle West Capital Corp. (PNW)
— UGI Corp. (UGI)
— NextEra Energy Inc. (NEE)
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6 Best Utility Stocks to Buy for Dividends originally appeared on usnews.com
Update 05/04/22: This story was published at an earlier date and has been updated with new information.
