Utility companies are one of the most conservative stocks one can own. The companies are heavily regulated government entities that provide our water, electricity and heat. They produce slow, steady returns and are unlikely to have many highs or lows due to the predictable nature of the business. But owning a portfolio of utility stocks comes with hidden risks.
In 1952, University of Chicago economics professor Henry Markowitz published a paper that expressed his modern portfolio theory (MPT). His idea was that stock portfolios should be diversified to reduce risk and increase returns over time. Utility stocks are among the most conservative stock investments. These stocks must be balanced with high growth stocks to achieve the most efficient portfolio returns under MPT. Consolidating your portfolio in utility stocks will virtually guarantee low returns.
Natural disasters present a risk to utility companies because they have the potential to knock the utility off line. In addition, utility companies incur overtime costs for extra workers to repair damage from the event. Natural disasters are unpredictable and cannot be built into financial models with confidence. In 2005, after Hurricane Katrina, the Empire District Electric Company's earnings were so bad that they did not cover the projected dividend; as a result, the value of the company decreased.
Government regulation poses a threat in every industry. But utilities are especially regulated and have a greater risk than many other industries to changing regulations. When the government makes a regulatory decision, it can radically affect the price of utility stocks. The government has placed increasing restrictions on companies that produce energy with coal; these pollution prevention requirements reduce company income and could endanger a company's existence.
Expansion Period Opportunity Cost
A portfolio weighted toward utilities will pay a heavy opportunity cost during a period of expanding economic activity. During economic booms, stocks in growth sectors such as high-tech, pharmaceuticals, finance, travel and manufacturing appreciate rapidly. Without these types of returns over time, your portfolio will badly lag the market indexes.
Kathy Zheng is a personal financial planner. She holds a Bachelor of Arts in economics and is certified as a level 1 financial adviser.