When it comes to paying consistently high dividend yields and offering attractive returns on a risk-adjusted basis, hardly any sector can beat electric utilities. And not only do the stocks in the electric utilities sector pay relatively higher yields than other investment vehicles, they also do it by trading with a much lower volatility than the broad market. Now that a meaningful yield is scarce and the economy is descending into recession, investors in pursuit of attractive and stable income should flock to the electric utility sector.
Electric utility stocks are considered defensive, recession-proof equity investments that offer safety during the market's volatile periods. They are the "least economically sensitive of the major equity market sectors," because their revenue streams and profit outlooks are fairly stable, operational risk are comparably lower, and the demand for power is inelastic. Electric utility stocks are generally less volatile than the broader market, as their financial performance is rather predictable. And, in particular, electric utilities boast dividend yields that well exceed those of the broader market and other industry sectors.
In the current yield-starved environment, the electric utility sector's dividend yield averages 3.5%, which exceeds by full two percentage points the average yield on the broad Russell 2000 index and by almost 1.5 percentage points the average yield on the large-cap S&P 500 index. When compared to the yield on the 10-year Treasury bond, the spread is again more than 2 percentage points wide.
The high spread between electric utility stocks and the 10-year Treasury bond is telling. Historically, the average dividend yield on utility stocks has traded at a slight discount to the 10-Year U.S. Treasury bond yield. Now, the average yield on electric utility stocks is trading at a major premium to the 10-Year U.S. Treasury bond. Empirical research shows that the yield spread premium is as a good leading indicator of returns for utilities stocks. Fidelity Investments thus predicts high total returns for utility stocks in the forthcoming period given that "after yield spreads last peaked in 2003, the utilities sector produced annualized total returns of 18% and 17%, respectively, over the next three- and five-year periods."
Some consider that the investors' rushing to the high-yielding electric utility stocks has already made the stock prices of electric utilities excessively high. Indeed, the electric utilities sector has traditionally traded below the market, based on the price-earnings ratio. However, today, the overall sector is trading on par with the broad market's P/E of 15.6. While this means that the demand for industry plays has been robust, there are still opportunities to capture high yield at relatively favorable prices. The table below shows several reasonably-priced electric utility plays with long-term earnings growth, high yields above 4%, and payout ratios below 70% of earnings:
Income investors should also pay attention to those electric utility stocks that pay relatively high dividend yield on a low payout ratio. Low payout ratios suggest that companies have ample room to boost dividends in the future. In fact, electric utility companies with high dividend yields and low payout ratios have outperformed historically.
There is a potential for income accumulation and stock appreciation in several electric utilities boasting dividend yields above 3% and dividend payout ratios below 50% of earnings. One reasonably-priced play is IdaCorp (IDA), a $2.2 billion power utility relying mostly on hydroelectric power. This utility pays a dividend yield of 3.0% on a payout ratio of 40% of earnings. Its P/E of 13.2 times is below that for the overall industry; still, the stock is up 7% over the past year. Another opportunity among these utilities is NextEra Energy (NEE). This utility has a market capitalization of $29 billion, a dividend yield of 3.4%, a payout ratio of 47% of earnings, and five-year dividend growth of 8% per year. The stock is trading on a P/E of 14, which is below the average ratio for the industry as a whole.
Investors should also focus on those stocks that have a proven history of raising their dividends. Some examples include Dominion Resources (D), Consolidated Edison (ED), Duke Energy (DUK), FirstEnergy Corp. (FE), Northeast Utilities System (NU), and UGI Corporation (UGI).