Utilities stocks have been favorite destinations for conservative, income-minded investors for decades. The sector is known for several things that risk-averse investors like. First, many large-cap utilities pay above-average dividends. Second, the sector is predictable; investors are exposed to severe earnings misses only rarely. Additionally, as part of a slow-moving, low-beta sector, utilities stocks historically fall less than the broader market during downturns. However, those factors do not mean the sector is risk-free.
Most U.S.-based large-cap utilities are regulated at the state and local levels. With many of these companies operating in multiple states, that means an increased burden on management to ensure the company does not fun afoul of regulatory guidelines. That is more of concern for the company than for investors. However, if a major utility gets into hot regulatory water in one state, Wall Street is not likely to care about the fact that the same company operates in 10 other states. When companies draw the ire of regulatory bodies, it is rarely good for the stock, regardless of sector.
For decades, more than half of the electric power in the United States was generated with coal. Electric utilities started to drift away from coal in the 21st century as a shale boom made the nation one of the world’s largest natural gas producers. Then when gas prices collapsed during the 2008 financial crisis, utilities embraced heavier natural gas use because it was cheaper and cleaner. The bad news is that as natural gas prices and demand spike, utilities could be forced to use more coal. The worse news is that emerging markets could stoke coal demand, driving prices higher. Utility companies could be faced with higher prices at the same time for the two commodities they most depend on.
Growth Stocks in Favor
Utilities they tend to prove durable during market downturns. However, that cuts both ways. In a legitimate bull market in which investors favor high-beta growth stocks in sectors such as technology, investors holding utilities stocks are likely to see their returns underperform the broader market.
Interest Rate Risk
A high interest rate environment is often viewed as extremely bad news for utilities stocks, for two reasons. Electric utilities are capital-intensive businesses that often carry large debt loads. When interest rates rise, so does their cost of financing debt. And because those higher debt costs strain some balance sheets, some utilities pare or suspend dividends when interest rates are high.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.