After surging more than 20% over the first six months of the year, utility stocks have declined over the rest of 2016. Investors are increasingly relinquishing their positions in safe options as rotating into cyclical stocks becomes the order of the day. With the Fed preparing to raise rates, the outlook for utilities stocks looks bleak at first glance.

However, investors in search of income will continue to seek out stocks from this sector with strong dividend yields. Additionally, utilities should continue to make up a certain portion of your portfolios in order to safeguard your hard earned gains. Most importantly, the outlook for these stocks may not be all that bleak, which makes it a good idea to pick select options with strong fundamentals.

Consolidation Increases, Growth to Expand Asset Base

Within the sector, the tendency toward consolidation continues to rise. Nearly $54 billion worth of mergers and acquisitions were completed in the conventional utility sector over the first nine months of 2016. According to acclaimed value investor Mario Gabelli, the current number of 81 publicly traded utilities is simply too many. This will ensure that the trend of mergers continues going forward. In such an event, larger companies will see profits increasing as they acquire smaller operators.

Additionally, a projected pickup in economic activity accompanied by large capital investments planned for 2017 will lead to an expansion of utility regulated asset bases. According to industry association Edison Electric Institute (EEI), around 51 utilities are planning to invest more than $90 billion to upgrade facilities and expand their capital bases.  

Trump Administration, Lower Costs to Aid Sector

Utilities have benefited significantly from a long period of low interest rates. At 9.57%, the average approved return on equity for the second quarter was the lowest recorded in more than 25 years, according to the EEI. This is also in line with the long term trend of falling ROEs.

However, the average cost of capital for several utilities has declined at an even faster pace. According to a study by New York University released earlier this year, the average cost of capital for 38 utilities was 4.1%. Gabelli has also emphasized recently that the decline in profits is not as drastic when examined relative to the concurrent fall in cost of capital.

Meanwhile, a Trump administration is widely expected to favor utilities. Trump’s promises to deregulate the sector and remove environmental hurdles will be hugely beneficial for utilities. Fewer regulations would result in a reduction in operating costs and an increase in life of power production facilities. Companies with large exposure to coal probably stand to gain the most from such measures.

Our Choices

Utility stocks have struggled in recent months but will continue to remain strong investment choices over the long term. The market will eventually change course at which point they will be good options to protect your profits.

This is why adding select stocks from the sector continues to a prudent option. However, picking winning stocks may be difficult.

This is where our VGM score comes in. Here V stands for Value, G for Growth and M for Momentum and the score is a weighted combination of these three scores. Such a score allows you to eliminate the negative aspects of stocks and select winners. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at a VGM score.

We have narrowed down our search to the following stocks each of which has a Zacks Rank #2 (Buy) and a good VGM score.

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Performance of Top Picks Vs Sector (Last 3 Months)

Great Plains Energy Inc. (GXP - Free Report) engages in the generation, transmission, distribution and sale of electricity to customers located in all or portions of numerous counties in western Missouri and eastern Kansas.

Great Plains Energy has a VGM Score of A. The company has expected earnings growth of 31.3% for the current year. Its earnings estimate for the current year has improved by 0.5% over the last 30 days. The stock has a dividend yield of 4%. The stock has returned 3.1% over the last three months, outperforming the Zacks Utility Electric Power sector, which has lost 2% over the same period.

DTE Energy Company (DTE - Free Report) is a holding company with subsidiaries engaged in regulated and unregulated energy businesses.

DTE Energy has a VGM Score of B. The company has expected earnings growth of 9.3% for the current year. Its earnings estimate for the current year has improved by 0.1% over the last 30 days. The stock has a dividend yield of 3.1%. The stock has returned 7.7% over the last three months, outperforming the Zacks Utility Electric Power sector, which has lost 2% over the same period.

Hawaiian Electric Industries, Inc. (HE - Free Report) is a holding company with subsidiaries engaged in the electric utility, banking and other businesses operating primarily in the state of Hawaii.

Hawaiian Electric Industries has a VGM Score of B. The company has expected earnings growth of 6.3% for the current year. Its earnings estimate for the current year has improved by 0.2% over the last 30 days. The stock has a dividend yield of 3.8%. The stock has returned 11.9% over the last three months, outperforming the Zacks Utility Electric Power sector, which has lost 2% over the same period.

PPL Corporation (PPL - Free Report) is a diversified utility holding company. Currently, the company serves 10.4 million utility customers in the U.S. and the UK.

PPL Corp has a VGM Score of B. The company has expected earnings growth of 7.4% for the current year. Its earnings estimate for the current year has improved by 1.2% over the last 30 days. The stock has a dividend yield of 4.5%. The stock has returned 0.6% over the last three months, outperforming the Zacks Utility Electric Power sector, which has lost 2% over the same period.

SCANA Corporation’s (SCG - Free Report) operations include generation, transmission, distribution, and sale of electricity to retail and wholesale customers in South Carolina.

SCANA Corp has a VGM Score of B. The company has expected earnings growth of 11.4% for the current year. Its earnings estimate for the current year has improved by 1.4% over the last 30 days. The stock has a dividend yield of 3.1%. The stock has returned 5.1% over the last three months, outperforming the Zacks Utility Electric Power sector, which has lost 2% over the same period.