Sport utility vehicles (SUVs) are rugged.
They have large tires, high ground clearance and four-wheel drive.
They allow you to traverse rocky terrain or snowy conditions with ease.
Basically, when the going gets rough, you want to be in an SUV.
Now, I like to think of utility stocks as the SUV of the market.
Only, I call them stress utility vehicles.
That’s because it gives us comfort owning utilities during times of financial market stress – like a recession or all-out panic.
The revenue streams of electric and natural gas providers are simply less affected by fluctuations in the broader economy (known as the business cycle).
So they tend to outperform when uncertainty and volatility are high.
Sure, utility stocks themselves may go down during these times. But their steady cash flows and higher yields provide us with protection. It’s why they’re considered defensive stocks.
Let’s examine how the utility sector has performed in the past.
Putting Stress Utility Vehicles to the Test
As you can see, utilities outperformed during the two major, market-roiling events over the past decade.
But there’s a catch…
Over the long term, utilities tend to underperform the broader market on a total return basis.
This isn’t all that surprising, given their defensive nature. After all, investments with lower volatility tend to produce lower returns.
Think of it this way…
Sport utility vehicles are better for adverse weather conditions, but they don’t go as fast as sports cars when the road is clear on a nice, sunny day.
And utility stocks sure come in handy when fear reigns in the markets, but they don’t provide the high returns of growth stocks and cyclical stocks in the long run.
Utilities also happen to be particularly sensitive to rising interest rates, since high rates make their dividend yields relatively less attractive. However, I recently gave several reasons as to why interest rates will probably stay low for a lot longer than most people expect.
Although, there’s another reason why utilities may underperform – share issuance.
SUV Buying Guide
When is a 4% yield really 0%?
When a company issues stock and increases its share count by 4%.
Over time, this equity shareholder dilution weighs on stock price performance and reduces earnings per share. And many utilities have quietly increased their shares outstanding.
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As you can see from the table above, the dividend yields on many utilities are far lower than one would expect once share issuance is taken into consideration.
Pepco Holdings (POM) has a nice 5.4% yield at first glance, but it has also increased its shares outstanding… by nearly 9% in the past year!
This is why we should be selective as to which basket of utilities we select for our portfolios. I say “basket” because it’s important to maintain diversification within the utility sector, as well, and not just select one stock.
AmeriGas Partners (APU), Ameren (AEE), Public Service Enterprise Group (PEG) and Wisconsin Energy (WEC) are all quality utilities that aren’t diluting shareholders. Duke Energy (DUK), the largest component of XLU, is also a solid pick.
Bottom line: Defensive utilities can be beneficial additions to our portfolios. Just don’t forget to abandon these stress utility vehicles and jump in the sports cars (growth and cyclical stocks) once the next crisis has reached a crescendo and everyone wants safety.
Safe (and high-yield) investing,
Alan Gula, CFA