Dividends are all the rage these days, and for good reason. Dividends serve to reduce a stock's volatility and provide meaningful downside protection when the economy takes a nosedive. But, with the Federal Reserve keeping interest rates near historically low levels, and with markets sitting near all-time highs, meaningful yield is hard to come by in the current environment.
If you're starved for income from your investments, utilities are often one of the first places to look for high dividend yields. At the same time, you should never buy a stock for its dividend alone. Investors need to evaluate the underlying businesses to make sure a company is actually earning what it's paying out to investors, and that future dividends will keep coming in.
Not all utilities are created equal
Utilities enjoy the benefit of virtually assured business models. After all, providing power is a matter of national security, and utilities operate within a highly regulated industry. This is how utility stocks are able to pass on such a high percentage of profits through to investors. There isn't much risk that utilities will see their businesses deteriorate, even when the economy goes south. That's because people will consume power even when under financial distress.
This has produced reliable profits for most utilities, and by extension, hefty dividend yields for investors. Consider that while the S&P 500 as a whole yields slightly more than 2%, utility dividends are several hundred basis points greater. Utilities such as Southern Company (NYSE:SO) and Duke Energy (NYSE:DUK) offer near-5% yields and maintain long track records of rewarding shareholders with strong dividend payments.
Southern has paid dividends for 263 consecutive quarters, a streak dating all the way back to 1948. Moreover, Southern has increased its dividend for 12 years in a row. Meanwhile, Duke Energy's track record is even more impressive. Duke has paid quarterly dividends on its common stock for an amazing 87 years in a row, and has provided increases to its payout for six years running.
Profits to power hefty dividends
Fortunately for investors, Southern and Duke Energy have the financial flexibility to finance their generous payouts. Southern earned $2.70 per share in 2012 profits, a 5% increase over the previous year. Meanwhile, the company current pays $2.03 per share in dividends to shareholders, representing three quarters of the company's 2012 profits. Southern's payout strikes a solid balance of a high current yield and enough cushion to provide modest dividend growth.
Ditto for Duke: The company registered adjusted earnings of $4.32 per share last year, while offering a $3.12 per-share payout. This means Duke is distributing 72% of its profits to investors, providing a 4.7% dividend that, like Southern, has room for modest growth in the years ahead.
Be on the lookout for utilities falling behind
Because of the reliable nature of utilities, investors may be tempted to think that their dividends are guaranteed. Unfortunately, this would be an oversimplification: utilities are stocks after all, which means there's always business risk. Underperforming utilities have cut their dividends before, and as you'd expect, it's delivered a devastating blow to investors.
Consider Exelon (NYSE:EXC) as a recent example of what can happen when a utility loses its way. Exelon is the largest owner and operator of nuclear plants in the United States, but unfortunately nuclear isn't doing very well right now. Exelon is struggling mightily this year and is seeing extremely weak results, particularly in its nuclear operations. Exelon's nuclear segment saw higher costs and a drop in production, as measured by total gigawatt-hours, in the second quarter.
This resulted in severely depressed profits. Exelon posted a loss in the first quarter and then followed up with 13% lower profits in its second quarter, year over year. Of course, it goes without saying that a company can't afford to pay a large dividend if it's reporting losses, and sure enough, Exelon slashed its payout by 41% earlier this year. As you'd expect, this was followed by a severe capital loss: Its shares lost more than a quarter of their value in just a few months.
Therefore, investors interested in the utility sector need to conduct the same due diligence they would for any other sector, to ensure their stocks are not only paying strong dividends today, but have the business strength to keep paying dividends down the road. In that vein, investors would be wise to give strong preference to Southern Company and Duke Energy, while avoiding Exelon.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Exelon and Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.