Utilities: Down But Not Out
The S&P 500 had a solid bounce-back year in 2023, returning roughly 24%. However, while the index’s return looked good, the lion’s share of the return was concentrated in the top handful of stocks. The seven largest stocks in the index—dubbed the “Magnificent Seven”—accounted for most of the index’s gains.
The other 493 stocks returned only 6% in 2023. In fact, of the eleven sectors in the S&P 500, four were either breakeven or had a negative return. Thus, it was far from a broad market rally.
No sector had a worst 2023 than utilities, which returned -7.2%. With interest rates high, the steady dividends utility stocks are best known for didn’t look as appealing. Additionally, the high interest rates made business more difficult because utilities are a capital-intensive business and they often need to borrow money.
Utilities Are No Slouch
But if we step back one year, utilities were one of the best sectors in the S&P in 2022. The sector returned 1.6% in a year the index returned -18.1%. Over the last ten years, utilities have an annualized return of 8.7%, which puts it in the middle of the pack. Furthermore, its standard deviation of 11.9% over this period shows that it’s less volatile than the overall S&P 500, which has a ten-year standard deviation of a little over 15%.
In other words, even though last year was really tough for utilities, over the longer haul as a group they have been a solid investment. They have rewarded investors with a solid return and less year-to-year fluctuations than the overall market.
Cheapest in a Long Time
Provided interest rates trend downward as expected by the market based on the Fed’s economic projections released at the end of last year, utilities should find a more positive environment in 2024. Using the ETF XLU as proxy, the P/E ratio of utility stocks ended 2023 at 13, the lowest year-ending mark in the last decade. Put another way, utilities as a group entered 2024 as the biggest bargains they’ve been in a while.
You may be thinking, maybe the P/E is going down because earnings are expected to fall. That’s a good thought but that is not the case. FactSet projects XLU’s EPS will increase by 7.5% this year—it grew by 6% last year.
Traditionally, utilities generate a steady flow of revenue and earnings because they are regulated. Authorities limit what rates they can charge customers. This also limits their growth. Some utilities have unregulated, market-based, businesses that offer more potential upside (but also more potential downside).
Regulation Isn’t All Bad
Regulation is a double-edged sword. While regulation does control what the utilities’ regulated business units can charge, it also guarantees a certain level of return.
Typically, the utilities need to show the regulator how much they’ve invested into the business—the investments could be for expansion, for safety improvements, for conversions to renewable energy, etc.—and the regulator will approve a rate increase by allowing a certain additional percentage return above what it determines to be the fair value of the investments. This results in not only downside protection but also some insulation against inflation. When costs rise, the rates utilities can charge can rise, too, particularly in states with regulators that are supportive of business investment.
Additionally, utilities are effectively state-sanctioned monopolies. They don’t have to worry about competition. And thanks to the nature of their business, they are less sensitive to business cycles than most other types of businesses. You aren’t going to become super rich just by investing in utilities, but if you are looking for stocks that pay a steadily-growing dividend and provide downside protection, utilities are well worth consideration.
PS: Do you seek peace of mind in today’s uncertain investment climate? As you position your portfolio for 2024, turn to utilities stocks.
Utilities stocks offer growth, income and asset protection. That’s an unbeatable combination. But you need to pick the right ones. For our list of the highest-quality utilities stocks, click here now.