EC Slim Pickings In The Utilities Sector

Introduction

This is part 19 and the final part of my series covering all the various sectors reported by FactSet. However, the popular idea of saving the best for last does not apply in this instance. As I indicated throughout each installment, there were some sectors that I felt offered better investment opportunities than others. Furthermore, I attempted to indicate that growth coupled with purchasing that growth at a reasonable valuation was a major key to long-term investment success. Stated very simplistically, a faster-growing company will generate significantly more future cash flows (and dividends if they apply) than a slower growing company will. It’s not only common sense, it’s a mathematical reality.

With that said, the Utilities Sector is largely recognized as being comprised of some of the slowest growing companies in all the market. However, the Utilities Sector is also recognized as providing higher levels of dividend income than the average dividend paying company. Consequently, there are many investors that have historically and are currently utilizing utility stocks as bond alternatives. However, please don’t be confused by that statement. This is not the same as saying that utility stocks are as safe as bonds.  Instead, this simply implies that utility stocks offer higher yields than the average stock and thereby provide some of the benefit that bonds traditionally have offered.

Furthermore, people are looking to utility stocks because even though they tend to be low growth entities, the good ones do have a legacy of increasing dividends each year. Therefore, although bonds provide the theoretical safety of having your original investment returned at the end, they do not necessarily provide the security of protecting your purchasing power. Inflation eats at both the income you receive from a fixed investment and the future purchasing power as well. Consequently, an alternative option such as utility stocks can provide an inflation-fighting rising dividend income stream, as well as modest capital appreciation.

Low Growth Utility Stocks and The Importance of Valuation

Regular readers of my work know that I am literally obsessive-compulsive about only investing when valuation makes sense. However, valuation is even more critical when investing in slow-growing investments such as utility stocks. One of the primary advantages of only being willing to invest at fair valuation is that it positions you to earn returns that are consistent with the operating results that the company produces.

Investing when overvaluation is manifest reduces your returns while investing when undervaluation is manifest can increase them. Therefore, when growth potential is low there is little to no margin of error or safety. If you even slightly overpay for a slow growth stock such as a utility, you are very likely to earn unsatisfactory long-term returns. Moreover, you will earn these lower returns at elevated levels of risk. Higher risk and lower returns are the exact opposite of what prudent investors seek.

The key to understanding this is to understand the realities of compounding. Any investment is ultimately worth the amount of cash flows or earnings that it can generate for its stakeholders. In simple terms, a slow-growing entity such as a utility stock does not produce a large enough stream of future cash flows to provide a margin of safety. Therefore, even the slightest miscalculation can devastate future returns. In contrast, a faster-growing entity produces a much larger future stream of income thereby providing a greater margin of safety. Of course, that assumes that the faster growth does manifest.  I will be expanding on this in the analyze out loud video later in the article.

A Sector By Sector Review

This is part 19 – the final installment in my series where I have conducted a simple screening looking for value over the overall market based on industry classifications and subindustry classifications reported by FactSet Research Systems, Inc.

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Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit ...

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Comments

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Moon Kil Woong 4 weeks ago Contributor's comment

Good points on valuation. Many are in this sector for the dividends and that alone. This will be a tough sector, especially if oil prices rise.