What are utility stocks and why should I invest in them?
Utilities are an important part of developed societies. Imagine life without access to electricity, clean water, or garbage pickup services. Things just wouldn’t be the same.
Utilities companies have capitalized on the fact that simple consumer comforts like electricity and running water are overwhelmingly valuable. Some are among the largest companies in the world, generating stable revenues and consistent growth.
No wonder so many investors want to get involved in utilities stocks.
What Are Utilities Stocks?
Utilities stocks represent utilities companies that provide basic utility services and infrastructure. These companies provide electricity, water, sewage, natural gas, dams, waste management, or a mix of these services.
The basis of the utilities industry is that there will always be a demand for basic comfort services. As such, by building and maintaining the infrastructure associated with providing these basic comforts, consumers will sign up and profits will come. Utilities are one of the only sectors for which the “if you build it, they will come” notion still holds true.
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Utilities Stock Pros and Cons
Any time you make an investment, you should weigh the pros and cons. Every investment you make has potential risks and benefits. In terms of utilities stocks, here are the most pressing pros and cons to consider.
Utilities Stock Pros
Investing in a product or service that everybody wants has its perks. Some of the biggest benefits to look forward to when investing in utilities stocks include:
1. Strong Dividend Payments
Utilities companies are part of a highly regulated industry and cash flows are highly predictable. This makes the payment of generous dividends possible. As a result, it’s not hard to find utilities companies that have dividend payout ratios well above 50%.
Stocks that pay strong dividends become great income plays. Every time the company earns money, investors receive a paycheck.
However, it’s important to remember that not all stocks are created equal in any sector. So, if you’re in these stocks for dividend payments, make sure to research a company’s history of paying and increasing its dividend before making an investment.
2. Only One Way to Go: Up!
Experts hate it when someone says that a stock can only go one way. No matter what stock you’re invested in within any sector, there’s always a chance that you will experience declines. Nonetheless, if there’s one sector in which the strong players are most likely to see gains ahead, it’s the utilities sector.
Companies in the utilities sector serve the most basic consumer needs. Nobody wants to sit in heat all day in the summer or freeze all night during the winter. Everybody needs electricity, water, sewage, and other basic utility services.
As a result, the companies in the sector that have built the strongest infrastructure, and continue to expand their infrastructure, will likely continue to grow based solely on the fact that the human population grows every day.
According to Google, the U.S. population grows at a rate of just over half a percent per year. As a result, utilities companies in the U.S. watch as their target audience increases by more than half a percent each year. This audience increase helps to build revenues. At the same time, continued work in operational efficiencies across the utilities sector will reduce costs, only serving to expand profits.
The argument for positive movement among the top players in the utility sector is a compelling one, suggesting that the right moves in the space can lead to strong, yet stable growth.
3. Utilities Stocks Provide Economic Shields
Economic hardship happens. According to the Federal Reserve Bank of San Francisco, economic recessions take place about every five-and-a-half years and last for just under a year on average.
During economic recessions, market performance is generally poor. Concerns about economic growth lead to consumers saving more money and spending faltering. Corporations see reductions in revenue and investors look for safe-haven investing options, generally leading to a sharp decline in the values of stocks across the market.
Although utilities will see slight dips here and there, they are generally resilient in recessions. Once again, these are companies that provide basic human comforts that are in demand by every single human being on the face of the earth.
When economic conditions are concerning, consumers tend to stay home. This leads to increasing use of electricity, water, natural gas, and other home utilities. As a result, utilities stocks tend to take some of the smallest dips during economic downturns and tend to recover faster than stocks in any other sector.
4. Tax Advantages
High dividend sectors like utilities come with tax advantages. In particular, if you hold a utility stock for at least 60 days following the ex-dividend date of the stock, you are eligible for your dividends earned to be taxed as “qualified dividends,” offering up a lower tax rate.
Because utilities stocks are dividend plays, investors who invest heavily in these stocks will enjoy lower capital gains tax rates.
Pro tip: If you’re going to add utilities stocks to your portfolio, make sure you choose the best possible companies. Stock screeners can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Utilities Stocks Cons
Utilities stocks have impressive upsides and are worthy of being considered by most every investor. However, it’s not all butterflies and rainbows here. As with any sector, investing in the utilities sector has its drawbacks.
1. Relatively Slow Growth
Large blue chip utilities companies do have a strong history of stable value growth, producing strong long-term gains for investors. However, this growth is slow.
The best investments in the utilities sector are made in large, well-established companies. Growth in the values of these companies depends on increasing demand and the revenue generated from that demand.
There’s no doubt that demand is increasing, but the human population only grows so fast. While the development of a new technology, medicine, or consumer goods could lead to dramatic gains for some companies in a short period of time, these types of opportunities don’t usually take place in the utilities sector.
If you’re looking for rapid growth opportunities, the utilities sector isn’t for you.
2. Losses Do Occur
Utilities stocks are touted as stable investments that provide dividend income alongside strong long-run growth. However, there’s no such thing as an investment that’s 100% safe. Whenever your money is not in your hands, it can be lost.
Not a believer? Consider one of the most well-known former names in energy and utilities: Enron.
The company is now known as the biggest mistake made by investors in history. The company fraudulently said they were making loads of money when they were in fact losing so much that bankruptcy was imminent. As a result, thousands of investors lost millions upon millions of dollars.
Oftentimes, investors jump into the utilities sector under the guise that any investment they make in the sector will be safe. That notion couldn’t be further from the truth. Even when investing in utilities stocks, losses can happen, and investors need to do their research before shelling out their hard-earned money.
How Much of Your Portfolio Should You Invest in Utilities Stocks?
No single stock or sector should represent 100% of most investment portfolios. When you start investing, you hear a lot about diversification, and for good reason. Diversification protects your portfolio from significant losses, should one of the investments you make take a dive in value.
How much of your portfolio should be invested in utilities?
Answering this question with a blanket statement wouldn’t be fair to you. Allocation is an intimate process that takes unique aspects of your financial life and circumstances into account. Much of it depends on your investing style, your goals, and your appetite for risk.
Here are a few factors to consider when building your allocation strategy.
Your Exposure to Bonds
A properly diversified portfolio will generally have a mix of stocks and bonds. Bonds provide a lower-risk avenue for modest growth while stocks provide a higher growth potential with more volatility. Before you can dive into stock allocation, it’s important to consider how much of your portfolio will be invested in bonds so you know how much is left to allocate to stocks.
The amount of your portfolio that you allocate to bonds will depend on your appetite for risk. Higher-risk portfolios have lower exposure to bonds while lower-risk portfolios have higher exposure to bonds.
A good starting point to decide how much exposure you will have to bonds is to consider your age. If you’re 35 years old, allocating 35% of your investment portfolio to bonds is a relatively centered approach. If you’re looking for higher potential rewards and willing to accept larger risks, adjust the bond allocation down by up to 10 percentage points. If you’d like to take on less risk than the average Joe, adjust the bond allocation upward by up to 20 percentage points.
Your Goals as an Investor
Every investor enters the market with the same overall goal: to make money. However, the reason for your drive to make money may differ from that of your neighbor. You may be interested in creating a long-term retirement income while your neighbor wants to capitalize on the short-term momentum seen in some stocks. Both of you will go about investing in different ways.
If your goals as an investor are to create steady, long-term growth that comes with dividend income, utilities stocks should represent a sizable portion of your stock allocation. If your goals are to generate large profits in a short-term setting, utilities stocks shouldn’t make up much of your portfolio at all.
Of course, your goals may differ from the examples above. The key to remember here is if your goals consist of less risk and long-term rewards, high-dividend utility stocks are attractive. If you’re in it for quick trades or short-term investments in hopes of capitalizing on a momentous move in value, utility stocks aren’t your play.
The 5% Rule
When determining your stock allocation strategy, whether you’re investing in utilities or any other sector, the 5% rule is a good rule of thumb for beginners to follow. The rule suggests that you should never invest more than 5% of your portfolio into a single stock, or into any group of high-risk speculative investments.
This means that if you’re interested in the relatively low-risk utilities sector, no more than 5% of your total portfolio value should be invested in a single utility stock. However, you don’t have to max out the full 5% allocation on all the utilities stocks you own.
For example, say you’re interested in utilities stocks A, B, and C. You believe that stock A is a sure bet, stock B is a close second, and stock C comes with some risk but it’s an interesting play that you’d like to be part of. In this case, your allocation might look like this:
- Stock A. Because you have such strong, research-driven convictions that stock A is going to be a sure winner, you invest the entire 5% allocation in this stock.
- Stock B. You’re interested, and you’re pretty sure things are going to work out, but you don’t want to risk the full 5% of your portfolio on this company. So, you invest 3% of your portfolio to provide a decent level of exposure but offset for perceived risks.
- Stock C. You’re on the fence with stock C. It could go either way, but you believe that if it moves up, it will see gains that outperform the sector as a whole and you don’t want to miss it. In this case, you might invest 1% of your portfolio value to provide exposure to the company while keeping in mind that the stock isn’t worth risking much more.
The 5% rule has diversification at its core. While no investment portfolio is 100% risk-free, by following the 5% rule, you will greatly reduce your exposure to significant losses regardless of the sector you’re investing in.
Utilities stocks are a great option for the right investor. These stocks are known for providing slow, steady growth and returning value to investors by way of dividend payments.
Although there are plenty of benefits, utilities stocks are not for everyone. Due to the slow-and-steady nature of their growth, these stocks are not a good choice for investors with a heavy risk appetite who are looking for stocks that offer more momentum — unless utilities stocks are used as a safer play to balance risk in these high-risk portfolios.
It’s also important to keep in mind that whatever sectors you decide to invest in, including the utilities sector, there will always be risk. It’s important to take time to research and understand the risks you take on when making investments and balance these risks against your goals before you pony up your hard-earned greenbacks.
Do you invest in utilities stocks? What are your favorite names in the utilities sector?