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Over a week ago I wrote an article about finding the right electrical utility for an income portfolio based on the generally-accepted fact that utility stocks provide a measure of safety and pay higher dividends for those seeking yield. Using screening and fundamental analysis methods that seek to target undervalued companies that may be safer than their industry peers, I was able to come up with a list of 5 possible stocks that met that criteria and selected my top choice from them.

I received a lot of comments on the article suggesting that while utilities are typically regarded as safer choices for the income-minded investor, they are currently at a high risk to rising interest rates - the point being that it may be best to look elsewhere for income as the outlook for utilities is beginning to turn bearish. While there are definitely certain advantages to owning utilities, there are also risks that investors should be aware of in order to effectively manage their portfolios. In this article I'd like to address some of those concerns, including:

  • Common reasons why interest rates rise - to see if the threat is currently credible.
  • Reasons why utility stocks are so sensitive to a long-term rise in rates.
  • What happens to utility stocks when rates rise and the market turns south?
  • Reasons why certain utility stocks are still a decent choice for investors during times of rising rates.
  • Finding utilities that are best prepared combat a rise in interest rates.

Are Interest Rates Rising?

First, consider some of the common conditions that will usually lead to a rise in rates and are currently taking place:

  1. Inflation
  2. A growing, strong economy
  3. Expectation that the Federal Reserve will begin tapering QE and raising rates

I would argue that those 3 reasons are currently valid. They are taking place in the economy right now and rates are rising as a result. Look at the charts for 10 and 30-year Treasury yields as well as AAA corporate bond yields, both on the rise this year. A search for mortgage rates will also show similar results this year.

(Source: Bloomberg)


(Click to enlarge)

(Source: St. Louis Fed)


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The 10-year treasury is up 73% this year, the 30-year treasury is up 39%, and AAA corporate bonds are up 37%. It's safe to say that rates are rising.

How Are Utilities Affected?

The utility industry has benefited greatly recently due to depressed interest rates. Income investors have flocked to them in search of yield as other sources have been held in check, largely due to the U.S. government pumping $85 billion a month into the markets to hold rates down and stimulate the economy. Thus we have seen utilities perform extremely well driving them to more expensive levels than they have historically averaged. Take a look at some current averages for the utility industry:

Price/earnings (TTM) 20.3
Price/book 1.68
Estimated 5 Yr EPS growth (-3.24%)
Avg. Yield 4.36%
Avg. Payout Ratio 68.3%
5 Yr Avg. Dividend Growth 3.47%
Beta 0.584
Return on Assets 3.35%
Return on Equity 7.33%
Quick Ratio 0.7

*This data was sourced from E*Trade and is comprised of 226 stocks in the utility industry. I'll be referencing this table later when I look for some stocks that are safer from interest rate rises than their peers.

If rates continue to rise it will negatively impact the utility industry in two basic ways:

  1. higher rates increase utilities' interest burden because companies tend to be capital-intensive and therefore more heavily indebted
  2. higher rates cause income-oriented investors to gravitate away from riskier yield options in the equities markets to investments such as bonds, money-market accounts, CDs, etc.

I believe we have already seen this beginning to take place. When you look at the chart of total return for three of the most popular US utility ETFs - Vanguard Utilities (NYSEARCA:VPU); Utilities Select SPDR (NYSEARCA:XLU); iShares Dow Jones US Utilities (NYSEARCA:IDU) - you'll notice the recent declines over the past month. Also, looking to the summer months you'll notice the sharp decline from May due to the market's fears that the Fed would start tapering QE at that time.

VPU 1 Year Total Returns Chart
(Click to enlarge)

VPU 1 Year Total Returns data by YCharts

As rates continue to rise and QE begins to taper, investors can expect that the utility industry as a whole will begin to suffer declines in share price. Expect to see the current averages (P/E, P/B, etc.) from the table above contract toward more historical levels.

Can Investors Still Be Confident In Utility Stocks?

Over the short term ... maybe not. Over the long term ... Absolutely.

In the short term (i.e. the next 1-2 years) I would advise investors to be cautious when looking to purchase stocks in the utility sector. Rising rates will lead some investors out of utilities and will also put a damper on the companies' finances as they are more heavily indebted than other companies in the equities markets. This will mean a slower growth rate for dividends as well as dividend cuts in some companies. You see, utilities borrow a lot of money to finance their operations. As such, when rates are low they can afford to pay out healthy dividends much easier than when rates are high. When rates rise they spend more to pay the debt payments and have less leftover for shareholders in the form of dividends.

However, over the long term utilities are undoubtedly one of the safest investments one can make, especially in the equities markets. They provide essential services - water, gas, electricity - that are in constant demand no matter what the economy is doing. These are some of the most stable businesses out there. They reflect this by carrying a lower beta than the average stock in the market. Furthermore, when markets do turn sour they tend to hold up better as investors seek out safer investments. In 2008-2009 during the collapse of the equities markets, the utility industry only lost about 1/2 the value of the overall indexes.

While the rise in rates may hurt the overall utility sector in the short term, seeking out companies that are best prepared to combat the negative effects of those rising rates will provide a safe investment and a decent yield to boot. Utility stocks will continue to do what they've done for years - provide investors with a safe means of income. They're not going anywhere as they provide services that all require.

I see the impending short-term decline in the sector as a buying opportunity for the income-minded investor who has been eyeing a few of their favorite utilities to snatch up some of these companies at a great price. It's always best to invest in utilities when they are trading historically low. Looking at the historical chart of most major companies in the sector will show that there are definite peaks and valleys in the share price. What's coming will be one of those valleys and a great time to invest in utilities.

Finding The Companies That Will Be Least Affected

Reason would lead me to suggest that the bigger, most followed/covered companies in the industry may be hurt worst, at least in terms of share price. They also tend to make up larger positions in the ETFs and Mutual Funds than the smaller, lesser known utility companies. The screening methods I use here don't take this into account, I'm just noting a thought. I also think that it isn't a coincidence that the larger, more well-known utilities such as Duke (NYSE:DUK) Southern (NYSE:SO) and Dominion (NYSE:D) did not make it through my screen.

RBC utilities analyst Robert Kwan suggests investors need to exercise care when selecting stocks in the sector. Specifically, he says "investors should look for two things in particular: companies with higher-growth profiles and long-term contracts, and those companies with regulated assets that can offset the impact of higher interest rates by boosting the rates they charge customer."

Using E*Trade's stock screening tool, I narrowed down the list of electrical utility stocks from 148 to a total of 5 worth consideration for being safe(r) from rising rates. *See my introductory link to my previous article as to why I look for electrical utilities (I operate in the industry and can evaluate them better than gas/water/consolidated utilities)

  • Electrical Utility Industry: 148 stocks
  • P/E ratio below industry average: 103 stocks
  • P/B ratio under 2: 66 stocks
  • Debt/Capital ratio below industry average: 42 stocks
  • EPS and Sales growth positive for next FY: 18 stocks
  • Payout ratio below industry average: 6 stocks
  • 5 Yr positive dividend growth: 5 stocks

What remained was a list of stocks that are better prepared to combat future rate rises than their peers for the following reasons:

  1. They carry less debt
  2. They are growing faster
  3. They are fundamentally cheaper (lower P/E, P/B ratios)
  4. They have grown their dividends
  5. Their dividends are safer (lower payout ratio)

The stocks remaining after screening to eliminate the candidates not meeting these requirements were:

  1. Consolidated Edison, Inc. (NYSE:ED)
  2. DTE Energy Co. (NYSE:DTE)
  3. Alliant Energy Corporation (NYSE:LNT)
  4. Cleco Corporation (NYSE:CNL)
  5. Northeast Utilities System (NYSE:NU)

I believe these 5 companies represent a great starting point to finding a safe utility to invest in that will have a higher level of safety from rising interest rates. The next step is to evaluate these companies and compare them to one another, which I like to do by looking at a combination of statistics - historical, current, and future. Using data compiled from a number of sources (Reuters, Zacks, Yahoo! Finance) I've done this work for you - take a look at the following table comparing past and present stats of the 5 companies:


(Click to enlarge)

Now compare future projections and analyst expectations/ratings:


(Click to enlarge)

Every investor has their own style and method of evaluating stocks and making a purchase decision. As such, you will want to adjust the data used from what I've included in my tables. Perhaps you care more about quick ratio vs. current ratio, or you don't care what the institutional holdings for a stock are. Great! That's what makes this so interesting - we're all different and trying to learn from the best! This is just a method I like to use to find stocks I may want to consider investing in - starting with a simple screen to eliminate the ones I don't want, then looking at side by side comparisons so I can score the remaining stocks against each other.

You'll notice that I proceed to highlight (in green) the top 2 stocks in certain categories and score them each 1 point for their leadership. Next, I highlight (in red) the bottom 1 stock in these same categories and score them -1 points for this. This is also an area where the individual investor can adjust to suit their personal styles. You could assign 1.5 points to growth-related categories if you weight future expectations more than past results. You could do the same for the debt related categories, etc. Regardless, here's the total scores for each stock by using my rating system:

  • ED: -1 point
  • DTE: 5 points
  • LNT: 8 points
  • CNL: 6 points
  • NU: 7 points

Based on my findings, I feel it's safe to just take out Consolidated Edison from future consideration. The winners here are LNT and NU. They offer investors a good combination of growth and low debt compared to their industry peers, which is vital to pick a utility stock that will be safe from rising rates. I actually think that, with the exception of ED, one could make a case for any of the 4 other stocks mentioned here; all are worth further consideration and research.

Conclusion

The bottom line here, and main point of this article, is that despite the threat of rising rates and what that could mean for the utility industry, good investment opportunities can still be found. Companies with lower debt and better growth opportunity than their peers will provide investors with a safer choice and likely outperform relative to the industry. Utilities have been one of the safer investments throughout market history and rising rates will not change this fact.

The declining prices currently taking place across the industry should offer investors a great buying opportunity if it continues. Utility investors can afford to be patient. These are not stocks that are going to rocket up with huge gains in a matter of days or even weeks - even after posting significant earnings beats or raising guidance. So don't feel like you need to rush to get into a stock. Evaluate a company thoroughly, then watch and wait patiently, searching for buying indicators such as an RSI below 30 or a stock's price falling below historical moving averages. Stay abreast of current events and news regarding the company, as the utility industry is one of the most regulated you will find. Changes in government policies/procedures regarding utilities can have a pronounced affect on companies in the area.

Perhaps the easiest thing to do would be to buy one of the major utility ETFs and just pay someone else to do the hard work of following and analyzing companies for you. For me, I like LNT and NU as safer choices in the utility sector to combat a rise in interest rates.

Source: The Search For Utilities That Are Safe From Rising Interest Rates