Utility stocks have recently fallen out of favor among risk-seeking investors, despite their low valuations and solid return prospects. However, a slumping market might be just what this sector needs to start working again.
Challenging Times for Utilities
The Utilities Select Sector SPDR exchange-traded fund (ticker: XLU), which includes Consolidated Edison (ED) and Dominion Energy (D) among its top holdings, has experienced a 6% drop in value this year. The sector’s defensive nature, typically appealing to dividend investors, has been overshadowed by higher rates, a brighter economic outlook, and the resurgence of animal spirits in the market.
A Window of Opportunity
Surprisingly, this beaten-down sector now appears more attractive than it has in a while. One key factor to consider is valuation. Utilities are currently trading at around 17 times 12-month forward earnings, a significant decrease from the previous year’s value of just over 21. In fact, they are now 12% cheaper than the S&P 500, which trades at just over 19 times earnings. Last year, utilities even reached a premium value as high as 22% above the index.
Valuation and Growth
Valuations alone might be enough to entice investors to explore this sector once again. However, utility stocks also offer growth opportunities at these discounted prices. One important aspect to consider is the “rate base” – the total net assets minus liabilities of a utility provider. According to Mizuho Securities analyst Anthony Crowdell, assets are currently increasing as providers focus on constructing renewable energy plants faster than retiring old ones. For instance, Duke Energy (DUK) aims to grow its rate base at an annual rate of approximately 8% over the next two calendar years, reaching just over $115 billion by 2025, as reported by FactSet.
With attractive valuations and potential growth prospects, utility stocks could be an intriguing option for investors willing to seize the opportunity presented by this currently overlooked sector.
Utilities: A Lucrative Opportunity for Investors
The growth of the rate base is a crucial factor in the utilities sector. Strict regulations limit the amount utilities can charge their customers, and regulators only permit a narrow range of returns on assets. However, by expanding their asset base, utilities can also increase their earnings. In most states, utilities are allowed to earn close to 10% return on equity, which is the percentage of earnings compared to net assets. When returns dip below this level, utilities are often granted permission to raise prices. Consequently, earnings are projected to grow at a rate similar to that of assets, around 8% annually.
Profit growth in the utilities industry will naturally translate into dividend growth. Although utilities currently yield approximately 3.5%, slightly lower than the risk-free 10-year Treasury’s 4% yield, the expected 6% growth in dividends over the next few years makes them an attractive investment opportunity. Jason Ware, the chief investment officer at Albion Financial Group, attests that utilities make sense from a total-return perspective.
One particular company set to benefit from this trend is Entergy (ETR). With increasing earnings and dividend growth alongside its rate base expansion, Entergy has caught the attention of analysts. It is projected that the company’s earnings per share will grow at a rate of 7% annually, with dividends growing at 5% over the next two years.
Considering the decline in valuation, with the price-to-earnings ratio dropping to just over 14 times earnings from nearly 20 times last year, investing in Entergy stock appears even more appealing.
Utilities have recently fallen out of favor but now present themselves as low-risk stocks with substantial potential – a perfect investment opportunity at present.
