Morningstar | Shift Attention Away From Interest Rates to Find Top Utilities Picks
U.S. utilities now trade near fair value for the first time since 2015 after underperforming the S&P 500 by 14 percentage points since November. Although rising rates have pressured the sector in the short run, our analysis suggests long-term utilities investors should put interest-rate worries aside and focus on utilities' fundamental yield, growth, and valuation.In the short run, the road for utilities could be bumpy as rising interest rates shrink the dividend yield premium utilities investors have enjoyed for several years. The utilities sector's 3.5% dividend yield is now just 60 basis points higher than the 10-year U.S. Treasury yield, down from 230 basis points in mid-2016 before rates started rising. But the positive yield spread remains a bullish indicator. In the last 25 years, utilities investors never lost money over three-year holding periods if they bought when utilities' dividend yields were higher than the Treasury yield.
The absolute direction of interest rates has been an unreliable indicator based on our analysis. Utilities' two- and three-year returns during the last 25 years have shown no clear relationship with interest-rate moves. Utilities produced positive returns as often as negative returns during periods when rates were rising, and vice versa.
Utilities with higher dividend yields, better earnings growth, and depressed valuations should outperform their peers regardless of interest-rate moves. For income investors, we think Dominion Energy, PPL, FirstEnergy, and Duke Energy provide the best total-return packages.
For value investors, we think unloved utilities like Scana and PG&E offer attractive risk-reward opportunities as each works through its own challenges. Despite the headline risk, we think the market is pricing in a worst-case scenario for both companies.
For our full analysis and more on our top utilities picks, see our report "Will Utilities Fly or Flop?" published Sept. 7.
Dominion Energy is a holding company. Through its subsidiaries , the company is engaged in producing and transporting energy. The company's operations are conducted through its subsidiaries: Virginia Electric and Power Company, which is a regulated public utility that generates, transmits and distributes electricity for sale in Virginia and North Carolina; and Dominion Energy Gas Holdings, LLC, which serves as the intermediate parent company for the company's Federal Energy Regulatory Commission-regulated interstate natural gas transmission pipeline and underground storage systems in the eastern and Rocky Mountain regions, as well as for the liquefied natural gas import/export and storage facility.
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