- Utilities offer stability, inflationary protection, high yields, and less risk than the market.
- However, utilities aren’t all equal and a lot depends on their debt levels.
- A look at what’s offered around the globe shows that there are higher yields with strong potential currency tailwinds in Brazil and Australia.
The usual saying is that defensive investing won’t make you rich quickly but it can make you well-off over a longer period of time. Utilities are an excellent investment for those who don’t like get rich quick schemes and prefer to see their wealth slowly but steadily grow over time and give them inflationary protection.
In today’s article, I’ll discuss the benefits and risks of investing in utilities, how to approach them, how to find good investments, and I’ll discuss a few ideas.
Pros & Cons Of Investing In Utilities
What’s unique about utilities is their safety as you are going to turn on the lights this evening no matter what happens in your life or in the economy. Secondly, utilities are allowed to increase prices in line with inflation, and thus give excellent protection. Thirdly, utilities are excellent growth companies in areas that enjoy economic growth and have positive demographics and thus despite being boring and slow, over the long term, they also offer growth. Fourthly, the competition isn’t as fierce because setting up a utility business requires lots of capital and takes decades to build. Therefore, there is no incentive for new players to enter the market as then nobody would make any money. For example, if there is one transmission line, there is no point in building another one next to it.
On the negative side, you always have to be very careful which utility you invest in, not all are good. Some companies over-expand and build up huge debt balances which don’t allow them to be profitable, nor to grow. Such an example is Energy Future Holdings Corp for which Berkshire Hathaway (NYSE: BRK.A, BRK.B) recently made a $9 billion bankruptcy bid for its Oncor Texas business.
How To Invest
Oncor’s example clearly shows that debt is a big red flag for a utility. The higher the debt, the more the company is dependent on future developments that may or may not happen. Therefore, if you prefer less risk, companies with lower debts are the way to go.
The second thing to look at is valuations. Given the positive characteristics, utilities certainly don’t come cheap.
Price earnings (P/E) ratios are below the S&P 500 average because the growth is much slower, or at least utilities give the impression of slower growth. Utilities can only significantly grow by acquiring other companies.
The current decline in energy prices has trimmed the growth in revenue in the past few years. However, many utilities are constantly improving their operations and manage to increase their dividends. Southern Company (NYSE: SO), for example, has been increasing its dividend over time and expects to continue to do so at growth rate of 5% in the future.
Figure 2: SO’s dividend growth. Source: SO’s investor relations.
What’s also significant are the relatively high debt levels. It’s important to analyze how potential future higher interest rates are going to impact utilities, hopefully it will be possible for them to transfer higher interest expenses as a cost to the consumer in line with inflation.
Dividend payout ratios are also very different. Companies that have high dividend payout ratios are more focused on current shareholder satisfaction than on future shareholder value creation. Average net after tax margins for the above companies are around 10%, so the fact that many of them pay out huge portions of their earnings into dividends could be questionable because it looks like more value could be created by reinvesting. However, the attitude is logical given the extremely low interest rates.
To conclude on U.S. utilities, what you can expect in the long term is slow growth and dividends in the range from 3% to 5%. The major risk comes from potential higher interest rates. If the FED raises its interest rate to 3% and U.S. Treasuries consequently yield 5%, the expected return rate from utilities will be above 7% and thus stock prices would definitely suffer. However, those who reinvest their dividends would rejoice because they would be able to buy more at lower prices and consequently increase their future total returns.
For those a bit more adventurous, it’s good to look abroad for good utilities as those are often cheaper, with higher returns, and more growth potential. For example, Energy Company of Parana (NYSE: ELP), a Brazilian utility, has a P/E ratio of just 5.7 and a dividend yield of 3.4%. Future growth in Brazil and a better political situation there could strengthen the Brazilian Real in relation to the dollar or euro and significantly increase your long-term dividends in your domestic currency.
If you think Brazil is too risky, take a look at Australia. The Aussie dollar is still weak and could turn around as commodities, the main Australian export, pick up.
Figure 3: USD vs. AUD. Source: Yahoo Finance.
While you wait for the Australian dollar to appreciate, you can enjoy nice dividends:
- AGL Energy Ltd (ASX: AGL) – 3.94%
- APA Group (ASX: APA) – 4.85%
- Ausnet Services Ltd (ASX: AST) – forward 2017 – 5.45%
- Spark Infrastructure Group (ASX: SKI) – 5.21%
So if you don’t have much time to invest and want a steady, secure return, utilities are a great way to go. They probably won’t make you rich in the next few years, but over a longer period of time where you automatically reinvest those fat dividends, you’ll probably be way ahead of the market and its craziness for hot stocks, especially if you invest around the world and use the dividends to buy utilities where they are temporarily cheap, and also take advantage of currency differences.
I’ll soon be writing about how to take advantage of long term currency trends, so make sure to keep reading Investiv Daily so you don’t miss out on valuable investing insight.