Utility stocks are attractive to many investors because of their reputation for conservative growth. They provide us with basic needs like water, electricity, natural gas, and sewer services, and because they're considered a public service, government regulators have strong oversight of their business practices.
Yet the sector has changed dramatically over time. While some utility companies are still subject to extensive regulation that limits their expansion but guarantees modest profitability and reliable dividend payments, others occupy highly competitive niches where the risks and potential rewards are much higher. To invest successfully in utilities, you'll first want to answer these three questions:
- Do you want the safety of regulated utilities or the growth potential of competitive utilities?
- Do you have any preferences about the areas on which you want a utility to focus?
- Do you want to invest in individual stocks or buy the sector via exchange-traded funds?
The question of regulation
Historically, most utilities fell into the category of regulated utilities. These companies were given monopolies over a particular region without facing antitrust scrutiny, but state governments retained the right to approve or deny proposed rate changes for each utility's customers. The general target setting rates is to give regulated utilities enough money to cover their operational and maintenance needs, along with a modest profit for its shareholders and other investors. Companies in this category tend to have stable earnings that grow at a steady but relatively slow rate. Their combination of slow growth and high levels of debt to finance capital investment make regulated utility stocks sensitive to interest rate movements, and they therefore tend to act more like bond investments.
Deregulated utilities have arisen more recently. Changes in laws governing competition have allowed some utilities to focus on generating electricity and making it available to a wide range of customers, including regulated electric utilities and commercial power users. These companies can tap into growth trends and have their rates established by the open market rather than regulators. Although that heightens the volatility of their income, it also makes them better able to pursue opportunities when they arise in certain niche areas of the utility market.
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Which type of utility do you like?
The largest utility companies often offer multiple services, incorporating both electricity and natural gas. In the water business, companies tend to concentrate their efforts solely on that single utility, but you can find some that are highly localized while others have built up a presence across the nation.
And for all that they may have in common, utilities' fundamental characteristics can differ widely. For instance, relatively cheap natural gas has led over the past decade to a spike in conversions, with customers in the Northeast trading in older heating-oil-fueled furnaces. That has dramatically lifted the volumes of natural gas sold by the utilities serving that region.
Investors so inclined can also pick stocks based on methods by which utilities provide their services. For example, some electric utilities are reliant of renewable energy sources like wind and solar to a much greater extent than their peers. If you engage in socially responsible investing, you'll want to pick utilities whose business practices reflect your values.
Stocks vs. funds
Finally, investors have to consider whether to buy individual utility stocks or to use funds. Individual stocks have the upside of allowing you to target particular types of utilities, geographical regions, generation-method priorities, and other characteristics that are important to you. If you buy just a handful of stocks, however, you'll be more exposed to company-specific risks.
Among the many exchange-traded funds that focus on utilities, the largest are the Utilities Select Sector SPDR (XLU +0.35%) and the Vanguard Utilities ETF (VPU +0.30%). Both hold shares of a wide range of different types of utility companies. More specialized ETFs let you focus on a particular niche of the industry while still giving you the diversification of a larger number of stocks held within the fund.
Use utilities in your portfolio
Utility stocks have served conservative investors well for decades, and even with changes in the industry, they remain a solid tool for producing reliable income from an investment portfolio. By considering these three questions, you'll be in a better position to make the right utility investments for your situation.
