As the year went by, utility stocks including American Electric Power (NYSE:AEP) and Consolidated Edison (NYSE:ED) suffered from widespread fears that actions taken by the Federal Reserve might serve to increase interest rates. This would then result in compressed profits across the utility sector, since rising rates would mean rising interest expenses for those companies, including utilities, that heavily utilize debt within their capital structures.
While it's easy to get swept away with stagnating share prices and rising interest rates as reasons to avoid utilities, long-term investors have plenty of reasons to keep owning high-quality utility stocks. Specifically, their extremely stable businesses, reliable profits, and high dividend yields make utility stocks excellent options for buy-and-hold investors.
Why the market fears the Fed
For most of 2013, valuations were compressed across many utilities because of how the Federal Reserve might act on its aggressive monetary stimulus. These fears materialized when the Federal Reserve announced it would taper off its monthly asset purchases designed to keep long-term rates down. Furthermore, the Federal Reserve has hinted that should the unemployment rate in the United States keep falling, short-term rates may be increased next year as well.
The end result is that utility stocks largely sat out the market's impressive rally this year. While the S&P 500 Index registered nearly 30% gains in 2013, utility stocks effectively missed out the rally. Some utilities, including Southern Company (NYSE:SO), actually declined this year, despite the fact that utilities register extremely reliable profits thanks to their stable business models.
Fears are much ado about nothing
It's true that rising interest rates will make it difficult for companies reliant on debt, including utilities, to refinance their debt at comparable rates. At the same time, some of the increase in costs will be offset by an improving economy more broadly. Higher interest rates are symptomatic with a normalized economy and a return to health—and those are not things to fear.
Put simply, 2013 represented nothing but a business-as-usual year for American Electric Power, Consolidated Edison, and Southern Company. They continued to do what they do best for their customers and their investors. Namely, each company provided reliable service, steady underlying profits, and hefty dividends. In fact, all three stocks raised their dividends this year. American Electric Power actually gave its investors two separate dividend increases.
Next year will be just the same. Each utility should see favorable rate outcomes that will allow for 10% return on equity, which will result in reliable (if unspectacular) growth. And, as has been the case for many years, these three utilities will pump out the majority of their earnings through to investors in the form of higher dividends.
Why these utilities now look attractive
Even better, the lackluster share price performance of utilities this year means many utility stocks now look attractive on a valuation basis. Whereas the broader market holds a trailing P/E multiple in the high teens, utility stocks are much less aggressively valued. Consolidated Edison, for example, trades for 15 times trailing earnings. American Electric Power expects to earn $3.15 in EPS this year, meaning it holds a valuation multiple of roughly 15 times as well. Lastly, Southern Company's adjusted earnings over the past four quarters totaled $2.68 per share, meaning the stock exchanges hands for 15 times earnings, like its peers.
Thanks to these low valuations, investors have the opportunity to secure 4% to 5% dividend yields, and reinvest those hefty payouts at low share prices. This means that those who understand the value of buy-and-hold investing will be able to compound their wealth even faster. That's why Foolish investors should view restrained utility valuations not as a curse, but rather as an opportunity.
Don't think that utilities are the only place for reliable dividend yields
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends 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.