How should I get started investing in utilities stocks?
While it’s not the sexiest category in the world, the utilities sector has long been a cornerstone in the stock market. Known as the home of dividend stocks, utilities are a favorite among income investors, while also being used as a hedge to add stability in portfolios built for more aggressive returns.
There are good reasons investors look to the utilities sector for stability and income — for the most part, the sector centers around the services that consumers wouldn’t be willing to live without. Natural gas utilities are vital to keeping consumers warm and safe in cold winters. Few Americans would be willing to go without running water or electricity being delivered to their home.
Ultimately, utilities are a safe play because everyone needs them. But how do you go about investing in this category?
How to Invest in Utilities Stocks
For all intents and purposes, investing in utilities stocks is just like investing in any other stock. You’ll start by doing your research to determine the best utilities companies to invest in, then go to your online brokerage account and purchase the stock you’re most interested in buying.
Before you actually dive in, you’ll need to know what to look for in a quality utility stock. Here’s what most investors are looking for when they buy into utilities.
What to Look for in Utilities Stocks
You don’t want to just jump on the first water, gas, or electric utility stock you come across. That’s because these companies come in all shapes and sizes, and some are financially stronger and better managed than others.
You want your investment portfolio to be full of winners. So, what does a winning utilities stock look like?
The best stocks in the category offer compelling dividends, have a strong history of stability during down markets, act as regulated utilities, and have a history of producing growth among various key metrics.
One of the biggest draws of investors to utilities is the fact that high dividends are an expectation among the best stocks in the category. According to Dividend.com, the utilities sector pays a whopping 3.47% annual dividend on average. Keep in mind, the 3.47% annual dividend is just the average as well. Some stocks in the category make payments far above average.
The reason for this is simple. For utilities companies, growth is relatively predictable. Everyone needs electricity, water, sewage services, trash pickup, and other services provided by companies in this category. There’s little question about whether these companies will grow. As long as the population grows, demand for these companies’ services will increase at a fairly predictable pace.
As a result, the best utilities companies don’t have to hold back a large percentage of their earnings to survive down times, or to invest in technological innovation. Instead, they can offer high dividend payout ratios, paying most of their earnings to their investors.
With that said, before diving into any utilities play, take a look at its dividend yield. If a utility company pays a yield under 3%, chances are you’ll find a better option to invest in with a little research.
Utilities stocks are also interesting to investors because of the stability they tend to provide. While all companies will have ups and downs, when significant downturns take place, the declines among utilities tend to be minimal compared to the market as a whole.
The reason for this is simple: most people refuse to live without utilities.
You might forgo a meal at your favorite restaurant if going out to dinner means you won’t be able to pay your electricity bill. And that cable bill isn’t quite as important as your water bill. When it comes to prioritizing bills, utilities are right up there with a mortgage or car payment.
As a result, even when the economy is in the dumps and the talking heads on financial media are saying the sky is falling, it’s more like business as usual for companies in the utilities sector.
If you intend to try your hand in the sector, you’ll want to look for companies that have a strong history of stability during these down markets. Open the stock chart for these companies and look over the past 10 or 20 years, comparing it to that of the S&P 500 or another major benchmark.
Take a look at how the company did during times when dramatic declines hit the broader market. For example, check out how it held up in 2020 as COVID-19 set in or during the beginning of the Great Recession in 2008. You’ll notice that even utilities fell, but if you’re looking at a strong utilities company, you’ll also notice that the stock’s decline was minimal compared to that of the overall market.
In general, your utilities stocks will be some of the safest holdings in your portfolio. So, take the time to look through the company’s history to ensure that it is indeed a safe play, even during down times in the overall market.
Is the Company a Regulated Utility?
There are two different kinds of utilities companies, and differentiating between the two is crucial when investing in the sector. These are regulated utilities and unregulated utilities.
If you’re new to investing in the sector, you’ll want to stick with regulated utilities companies until you learn the nuances of what makes these stocks move. Here’s the differences between the two:
Regulated utilities are companies that own the infrastructure needed to make the services they provide possible.
For example, a regulated electric company owns the power lines the electricity runs through to get to the homes it serves. A regulated water and sewage company owns the water mains and sewage lines that allow clean water to enter your home and sewage to leave.
These companies are the most stable of utilities companies because, due to their ownership of the infrastructure needed to provide service, they tend to hold monopolies in the areas they serve.
For example, if you live in any major population center in Florida, chances are your electricity services are provided by Florida Power and Light, a subsidiary of NextEra Energy (NYSE: NEE), which holds a monopoly in most major cities and suburbs in Florida.
That monopoly means that NextEra Energy will continue to benefit from services provided to highly populated areas in Florida for the foreseeable future, and it won’t have to worry about competition stepping on its toes.
As a result, new investors in the utilities industry are best served investing in regulated utility stocks rather than their unregulated counterparts.
Unregulated utilities are a more risky, less stable play than their regulated counterparts. These companies don’t own the infrastructure used to serve their customers. Instead, they lease the rights to use the infrastructure, paying a wholesale rate for services provided through it.
For example, if you live in a rural area of Texas, you may receive your electricity from a company that doesn’t own the lines it runs through. Instead, that electricity is generated and sent to you by a regulated company that’s charging your service provider a wholesale rate for each watt of electricity you use.
Unregulated utilities companies still come with lower risks than companies in many other sectors, but when it comes to the utilities sector, these are the high-risk players. They have no monopoly, so in order to grow, they have to work hard to sell their services to more customers.
Sure, there are plenty of unregulated utility companies that do very well for themselves, but until you become knowledgeable about the industry as a whole, it’s better to avoid them and focus your investing efforts on the more stable, regulated options.
As an investor, your ultimate goal is to make money, not lose it. Even if a stock pays compelling dividends, declines in the value of the stock itself are concerning. You want growth!
Keep in mind that few to no utilities stocks will produce the type of growth that you’ll see among the top players in high-growth sectors like technology, but that doesn’t mean you have to settle for stagnant price appreciation or, worse, declines in the stock price. The best utilities stocks will provide stable, albeit slow growth.
There are three measures of growth you’ll want to pay close attention to before investing in any utilities stock:
- Price Appreciation. You’ll want to make sure that the stock price has a strong history of growth. Look at the stock chart for the past several years. What you’re looking for is steady movement upward. As with any other stock, you’ll notice peaks and valleys, but overall, the movement should trend in the upward direction. If the stock is trending downward overall, look for other options for your investment dollars.
- Revenue Growth. Topline revenue is a measure of the amount of money the company brings in before expenses are deducted. It’s best to invest in companies with consistent revenue growth. To determine whether the revenue is growing at a company you’re interested in investing in, take a look at its annual financial reports over the past five years. You’re looking for a company that has consistently seen year-over-year revenue growth during this period.
- Earnings Growth. Regardless of how much revenue is coming in, if none of that turns to profit, the company simply can’t last forever. So, take a look at the company’s earnings reports at the reported annual earnings growth over the past five years. If earnings are consistently trending upward, you’re in good hands. Otherwise, it’s time to look for other opportunities.
Debt plays an important role in the utilities sector. Most companies in the sector use debt to cover day-to-day expenses, paying that debt off as agreed in the long run through the predictable earnings they generate from their business operations.
As with consumer debt, though, business debt can easily get out of hand.
Before investing in a company, regardless of the industry in which it operates, you’ll want to make sure the company isn’t drowning in debt. One of the best ways to check is to look at its debt-to-total-asset ratio.
Keep in mind that the utilities industry is capital intensive, so debt levels tend to be relatively high in this industry. It’s perfectly common for companies in the sector to have a debt-to-total-asset ratio ranging from 70% to 80%. However, if this ratio climbs above 80%, investors have a cause for concern.
Before diving into any investment in the sector, make sure that its debt is manageable. Stay away from any stock with debt representing more than 80% of its total assets, as this can be a telltale sign of a company struggling to stay above water. Finding a gem in the utilities sector with debt representing less than 70% of its assets is even better.
Finally, it’s wise to look into the longevity of a company before investing in it. After all, a company that’s been around for 50 years is far more likely to be around in another 50 than a company that’s only been around for three years.
Investors, particularly new investors in the industry, should only consider companies that have at least a decade or two of experience under their belts. This will help to ensure that the companies they invest in are relatively stable.
How Much Should You Invest in Utilities Stocks?
Just about everyone should have some exposure to the stability and income offered by the utilities sector.
It’s also important to keep in mind that diversification is key when it comes to any investment portfolio, both in terms of stocks and asset classes. The first step is to set your asset allocation between stocks and bonds.
If you’re not sure how to choose how much to allocate to stocks versus bonds, consider your age. As you get older, your portfolio should become safer because you’ll have less time to recover from downturns by the time you retire.
So, if you’re 35 years old, you might allocate 35% of your investment portfolio to bonds, leaving 65% to invest in stocks. If you’re 60 years old, you might put 60% of your portfolio in bonds, leaving only 40% for stocks.
Next, you’ll want to consider your investment strategy when deciding how much of your stock allocation to invest in the lower-risk utilities space. Keep in mind that these stocks will provide slow, steady growth, with income as a kicker.
If you’re an income investor, there’s nothing wrong with the majority of the stock side of your portfolio being invested in the sector. But if you’re a risk taker looking to generate significant growth, your exposure to the utility sector should be minimal — your goals will be better served with investments in areas like technology and biotechnology.
Remember that you should look to reduce your portfolio’s risk as you age, so reducing exposure to growth stocks and focusing your efforts on stable income stocks as you get older is often a positive move.
Consider Investing in Utilities ETFs or Mutual Funds
If you’re not interested in choosing your own utilities stocks to invest in, there’s no harm in letting the pros do the leg work by investing in exchange traded funds (ETFs) or mutual funds centered around the industry. These funds pool money from a large group of investors and invest according to a strategy spelled out in the fund’s prospectus.
These days, a large chunk of the total liquidity of the stock market is invested in investment-grade funds, and for good reason. There are plenty of options, allowing you to choose what sectors and investment strategies you’d like to follow with your money without having to make the tough decisions about what individual stocks to buy and sell, and when.
Some of the top funds in the sector include:
- Utilities Select Sector SPDR Fund (XLU)
- GlobalX Renewable Energy Producers ETF (RNRG)
- Vanguard Utilities ETF (VPU)
Pros and Cons of Investing in Utilities Stocks
As with any other investment, deciding to invest in utilities stocks will come with pros and cons. Here are the most important to consider.
Utilities Stock Pros
- Dividend Yields. If you’re looking for a strong dividend payout, you’ve found the right place. Wisely chosen stocks in the utility category are known to pay much better than average dividend income. This is because these companies’ predictable business models allow them to provide higher payout ratios.
- Stability. Utility companies are known for lower volatility. Cash flow is fairly constant when consumers truly need the services being provided, regardless of the state of the economy or the rest of the market. As a result, these stocks are great for risk-averse investors and perfect options for hedging bets in an aggressive portfolio.
- Low Risk. There’s risk associated with any investment you make. The Enron scandal showed that anything can happen, regardless of a company’s sector or perceived strength. Because utilities are necessary services, however, risks when investing in these stocks are far lower than in most other sectors.
Utilities Stock Cons
While there are plenty of reasons to consider an investment in utilities, there are also thorns on every rose stem. These are some of the biggest drawbacks associated with investing in the sector.
- Little Stock Price Appreciation. Utilities stocks are known for being stable income plays. However, in the market, risk is rewarded with price appreciation. Because these stocks come with low risk, their price appreciation is generally slower. If you’re looking for fast-paced gains, utilities shouldn’t make up most of your portfolio.
- Regulatory Risks. The best utilities companies have monopolies over the areas they serve. However, there’s a growing movement to change this. There have been several efforts on a state-by-state basis to introduce regulation that will give consumers more options. So far, these efforts have been unsuccessful, but there is the risk that one day, regulated utilities won’t be quite as safe as they are today because they could lose their monopolies.
- Natural Disasters. Although economic storms don’t cause much pain for utilities companies, natural disasters pose a significant risk. Following natural disasters like hurricanes or earthquakes, utilities may be offline for an extended period of time. Not only does this result in a lack of revenue during these times, but the utility companies must invest massive amounts of money into repairing damaged infrastructure. So, for investors, the risk of a natural disaster is ever present.
Utilities stocks are a great fit for most portfolios. Even in aggressive portfolios, the income and steady growth are a nice change of pace used to offset potential declines in riskier assets.
When investing in this category, it’s important to keep in mind that not all stocks are created equal. Each will have its own dividend yield, its own history of growth (or lack thereof), and its own potential for gains ahead.
Using this guide and taking the time to do your research prior to making an investment will help ensure that you find the best stocks in the utilities space and balance them well with other assets in your portfolio.