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.
PG&E is a holding company that conducts its business through Pacific Gas and Electric Company (Utility), a public utility engaged in the sale and delivery of electricity and natural gas to customers. The Utility generates electricity and provides electric transmission and distribution services throughout its service territory in northern and central California to residential, commercial, industrial, and agricultural customers. The Utility provides natural gas transportation services to small commercial and residential customers and to industrial, commercial, and natural gas-fired electric generation facilities that are connected to the Utility's gas system in its service territory.
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
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