No One’s Ignoring Energy Prices, So Why Is Everyone Ignoring Utilities Stocks?

Stéphane Renevier

4 months ago4:30 mins

No One’s Ignoring Energy Prices, So Why Is Everyone Ignoring Utilities Stocks?

Utilities stocks are in a weird place right now: they’ve barely managed to outperform the broader market since the start of the year, even as the prices of the electricity, gas, and other services they offer have skyrocketed. There are good reasons for that, sure, but you shouldn’t necessarily avoid them just because everyone else is.

Why haven’t utilities done better?

Utilities companies’ revenue might’ve increased, but so have the costs of the raw materials they need. Those extra expenses mean higher production costs and lower margins. And since utilities are heavily regulated, they can’t fully pass on those higher costs to customers.

In fact, even their profits tend to be regulated, with governments taxing any gains over an “allowed profit” in order to subsidize customers. And given how badly higher energy costs are stretching consumers’ disposable income (they now represent 20% of household spending in some regions, up from 7% a year ago), investors are only expecting regulatory pressures to increase.

Consider too that utilities’ high dividend yields and stable cash flows lead investors to treat them almost like bonds – less of a growth play and more like a fixed income asset. That makes them more vulnerable to rising interest rates, and ultimately less popular among today’s investors.

So why would I want to add them to my portfolio?

Thing is, utilities have the best aspects of bonds too.

Unlike many other sectors that rely on a booming economy to grow their profits, utilities provide services that are always needed, rain or shine. That defensiveness tends to prove valuable when the economy gets weaker. Plus, these companies tend to be heavily regulated legacy players with few competitors and predictable cash flows, meaning they can pay attractive dividend yields to investors. Those two features – resilience in economic downturns and reliable income – helps offset some of the damage of rising interest rates.

But as a stock, utilities also have the potential for significant capital gains. And right now, there’s good reason to believe they could be about to make good on that potential.

First, utilities are at the heart of the green energy transition, as more polluting sources of energy are phased out and greener sources phased in. The conflict with Russia – the main supplier of gas to Europe – has only accelerated that trend: European countries are focusing on improving energy efficiency and developing their own sources of energy to reduce their reliance on external producers.

And this is where things get interesting. Utilities have every incentive to invest in as many projects as they can, since their “allowed profits” are calculated as a margin of the assets they own. And since governments are trying to bring down their own countries’ emissions, they have every incentive to help them without putting regulations in the way. Just keep in mind that scaling up these renewable investments will take time: we might only be at the beginning of a super-cycle for renewable energy.

If you’re wondering why utilities stocks haven’t already reaped the rewards of this potential, that brings me to my second point. Investors have been so pessimistic about the short-term outlook for utilities that they’ve arguably pushed their valuations too low, with some of the highest-quality utilities companies trading below 10x their profits. That’s not necessarily significantly cheaper than their long-term average, but it’s arguably not high enough. And sure there are still plenty of headwinds – regulation, commodity costs, rising interest rates – in the short term, but they won’t all be around forever. And given the current pessimism, any positive surprise could lead to a significant rally.

What’s the opportunity here?

It’s true: utilities might not bring the triple-digit returns that some growth stocks bring in a bull market. But they’re likely to outperform the broader market in a bearish environment, even if they’re unable to avoid losses entirely. And that might be exactly what your portfolio needs right now: an asset that’ll help your portfolio withstand an economic slowdown, guarantee you some income, and – if you’re patient– offer the potential for some serious capital gains.

As for where to invest, US utilities will certainly benefit from the trend, but the risk/reward balance looks particularly attractive in Europe, where the transition to greener energy sources is gathering pace and regulation is less of a challenge. So you might want to buy a diversified utilities ETF: the iShares STOXX Europe 600 Utilities UCITS ETF (expense ratio: 0.46%) is your best choice in Europe, and the Vanguard Utilities ETF (ticker: VPU, expense ratio: 0.10%) in the US.

The issue with ETFs is that they invest in all types of utilities, but those with a focus on electricity and renewables are a lot more promising. Goldman Sachs has published a helpful list of its top picks for Europe:

Goldman Sachs' upside/downside of key stocks
Goldman Sachs' upside/downside of key stocks

Of all of them, three really caught my attention. Italian bellwether Enel has a strong exposure to renewables and a high dividend yield of 6.3%, and its valuation is looking low. Electricity supplier Engie is a solid company, with a high dividend yield of 7% and a cheap valuation. And finally, Solaris, which should benefit directly from Europe’s shift in energy policy.

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