What to consider when investing in utilities
Editorial staff, J.P. Morgan Wealth Management
- The utilities sector can be considered secular and defensive, as the steady revenues of utility companies are usually unaffected by changes in the economy.
- We are likely entering a new phase of growth for utilities over the next few years, underpinned by an increase in energy demand driven by artificial intelligence (AI).
- Higher rates tend to pressure utilities performance, as the sector’s dividend yield becomes less attractive on a relative basis.
If you’re thinking of investing in the utilities sector, there are a few things you need to know – especially in this environment of higher interest rates. Let’s break it down:
The utilities sector is on the defensive
The utilities sector is made up of companies that provide basic amenities like water, sewage services, electricity and natural gas. It is considered a secular, defensive sector because utility companies tend to have a steady revenue stream, and their performance is relatively unaffected by changes in the economy. “When times are bad, consumers are still purchasing these necessities,” said Abigail Yoder, a J.P. Morgan U.S. Equity Strategist.
Because of this dynamic, investors often treat utility stocks as long-term holdings. These shareholders may generate consistent income for their portfolios by taking advantage of the sector’s low volatility and the stable dividends offered by some utility companies.
This is why so many turn to the sector during times of economic turmoil – the consistent, stable returns of utility companies are especially attractive when it seems like everything else in the economy is going sour. Specifically, investors turn to utilities in a low interest rate environment because the companies’ dividends can be greater than Treasury yields. On average over the last 15 years, the S&P 500 utilities sector has had a dividend yield of 3.7%, comfortably above 2.5% for the U.S. Government 10-year over the same period.
However, even though the utilities sector tends to attract investors during economic downturns, the opposite is true when economic growth is on the horizon. As interest rates rise, shareholders can find higher-yielding alternatives elsewhere. Additionally, utility companies tend to be highly leveraged and often see their profits dwindle during periods of high interest rates.
“When you see deceleration in GDP, that’s historically been a good time to invest in utilities. But if the economy is growing quickly, that’s a bad time to invest in the sector,” Yoder said. “Higher rates create a more difficult backdrop for higher dividend sectors. When times are good, you want to lean more into cyclicals.”
Utility companies are heavily regulated and have a high cost of business
The utilities industry is heavily regulated, which means the companies within the sector have fewer competitors, giving them certain monopolistic capabilities. This can enable utility companies to have more predictable cash flows and profits.
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But even though regulation can provide utility companies with a fixed revenue stream, it also exposes these companies to some significant risks. Because utility companies provide necessary services to society, the government dictates how much these companies can charge customers. This means that utility companies have lower earnings potential, and the companies can’t adjust their prices when the costs of the commodities they rely on – like oil or gas – rise.
Because of this, regulations can increase the cost of doing business for a utility company. Utilities require a large amount of expensive infrastructure, so companies in the sector often carry a lot of debt to cover those costs. Utility companies tend to thrive in a low interest rate environment in part because the low interest rates can provide cheap funding for the substantial capital expenditures they need.
AI is leading to a step function higher in earnings growth for utilities
It may come as a surprise that in 2024, the best performing stock in the S&P 500 was not a tech company, but a utility company! This has largely to do with the potential for utility companies to benefit from the increase in power demand generated from the use of AI, electric vehicles and reindustrialization of the U.S., which is, in turn, increasing expectations for earnings growth for the sector.
New investment in the U.S. power grid infrastructure, the expansion of renewables and the increased power demand for data centers all support a longer-term growth story for the group. That does not mean, however, that utilities are evolving into a growth sector, and our strategists believe that not all companies will benefit the same, making stock selection important here.
Over the last 20 years (roughly), annual earnings have steadily increased for the sector. Looking forward, that year-over-year growth is above the average over the period (8% for 2024 to 2026 versus a 5% average since 2003), a result of some of these benefits.
Shareholders can invest in the sector via utility exchange-traded funds (ETFs), or they can purchase individual company stocks. Adding exposure to utility stocks can help provide you with a balanced, diversified portfolio that can potentially mitigate downside risk when the market falls and cyclical stocks underperform.
Utilities are starting to go green
Utilities are usually asset-backed services, and many companies in the sector are starting to produce these assets – like electricity – using renewable energy sources such as wind and solar power. As more consumers take an interest in renewable energy, this can provide a growth opportunity for the sector.
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Editorial staff, J.P. Morgan Wealth Management
