Utilities are highly valued by investors for their reliable, if unspectacular, growth. Utilities are routinely called 'widow-and-orphan' stocks, meaning they're commonly held for their hefty dividend yields and low volatility.
However, the past few months have seen more volatility in utility stocks than many investors would like. Much of it stems from fear of the Fed taper, the winding down of the central bank's monthly bond purchases. This, combined with the possibility of higher rates, has resulted in severe drops for many utility stocks.
Are higher interest rates reason enough to sell utilities?
An uncomfortably wild ride
In theory, utility stocks will decline in an environment of rising interest rates, since their yields would need to rise in conjunction with higher rates. In addition, companies reliant on debt financing, such as utilities, would see increases in their interest expenses going forward, dragging down profits.
After racking up double-digit returns over the first few months of 2013, these stocks have given back the bulk of the gains and are now close to flat or down over the past 52 weeks.
Steady business outlooks should reassure investors
Whether higher rates make utility stocks less attractive remains a possibility going forward, but on a purely fundamental basis these stocks will continue to do what they've done for many decades.
Power generation is an extremely stable business. Even under the most dire financial circumstances, consumers still need power.
This is indicative of these companies' steady results, even though their stock prices have implied considerable instability. Despite what their wildly swinging stock prices might suggest, it's business as usual for utilities.
Southern grew its adjusted earnings per share by 2.6% over the first half of 2013. Meanwhile, Duke Energy saw its second-quarter operating income rise 4.5%, and Consolidated Edison posted flat earnings per share in the first half of its own fiscal year.
Electricity is vital, and its societal necessity explains the fantastic track records of stable dividends these companies maintain.
Southern has paid dividends for 263 consecutive quarters—dating back to 1948. Moreover, the company has actually managed to increase its shareholder distribution for 12 years in a row. At recent prices, Southern yields 4.6%.
In February, Consolidated Edison raised its dividend for the 39th consecutive year, and offers a 4.1% payout.
Meanwhile, Duke Energy has paid dividends for 87 consecutive years and yields 4.3% at its current level.
Can these stocks power up your portfolio?
Utilities simply aren't right for every investor. Each investor needs to assess their own particular investing goals, because utilities are only appropriate for a specific type of investor. Those with a long time horizon and any sort of appetite for risk at all should avoid utilities.
For me, utilities should be looked at as a place to park cash over the intermediate term to generate income. As a result, utilities are best reserved for those investors in or near retirement, who are facing the prospect of income replacement.
On a standalone basis, utilities aren't performing poorly. The better ones, such as the ones in this article, are still doing their job: namely, reporting steady profits and paying strong dividends. This will continue for many years to come.
At the same time, higher interest rates will serve as an undeniable headwind. And, the inherent slow-growing nature of utilities means the potential for greater capital gains looks to be limited going forward.
If you're an investor who craves income, utilities will continue to provide just that. Most others, though, should look elsewhere for better opportunities.