Whether or not to buy utility stocks right now is no easy decision. On one side, proponents of utilities cite their steady profits backed by businesses that are virtually a matter of national security. In addition, their reliable earnings allow them to pay rock-solid dividends.
Indeed, many utilities like Southern Company (NYSE:SO), American Electric Power (NYSE:AEP), and Duke Energy (NYSE:DUK) sport dividend yields of nearly 5%, which goes a long way, especially in today's environment of historically low interest rates.
On the other hand, the last point may be cause for concern. Critics of investing in utility stocks say that as interest rates rise, shareholders will suffer from a double dose of pain. First, rising interest rates would incentivize investors to place their money elsewhere, which would cause share prices to fall to keep up with rising rates (since prices and yields are inversely related). Moreover, because the capital structure of utilities is generally debt-heavy, rising rates would make it costly to refinance this debt going forward, which would have a negative impact on earnings.
With all of this in mind, whether or not to buy utility stocks seems like a very difficult decision indeed. But really it's quite simple. It all boils down to your individual investment goals.
Pillars of stability
Southern Company posted flat earnings last year along with 3% growth in adjusted earnings. This allowed the company to give investors a nice 3% dividend increase in April.
American Electric Power grew its profits from core operations by 5% last year. Future growth is likely too, even with the potential impact of rising rates. Management maintains a long-term future target of 4%-6% earnings growth, driven by transmission growth, investment in its infrastructure, and cost cuts.
Likewise, Duke Energy shares a similar philosophy of modest growth and cost cuts to boost earnings. Duke's adjusted profits rose 1% last year. It realized synergies from its acquisition of Progress Energy. Like American Electric Power, Duke management expects to generate between 4%-6% growth in adjusted earnings per share each year through 2016. Further benefits from the merger, along with continued organic growth, should result in stable increases in revenue and profit.
Clearly, these companies aren't too worried about rising rates. Each company's steady performance allows it to maintain a very impressive track record of rewarding investors.
American Electric Power has paid uninterrupted dividends for more than 400 consecutive quarters. In fact, American Electric has a great track record of increasing its payout, which indicates its reliability. It gave investors two separate dividend increases just last year.
Duke Energy increased its dividend last year as well and has paid dividends for 88 straight years. This marks the 13th consecutive year of dividend bumps for Southern Company, which has paid a dividend for 266 consecutive quarters dating all the way back to 1948.
It's true that rising interest rates may cause short-term dips in stock prices, but it stands to reason that most investors don't buy utility stocks for their capital gains potential. Typically, most investors are in it for the dividends, which will keep rolling in even if rates rise from here. Consider their extremely long track records of paying dividends. You can be sure these periods encompassed all sorts of fluctuations in interest rates, but those payouts endured.
Buy utilities? It depends who you are
The bottom line is that while rising rates would have an impact on profits, these three utilities are well-run businesses that are more than capable of managing their capital structures effectively. While you shouldn't expect the share prices of Southern Company, American Electric Power, or Duke Energy to perform spectacularly in the face of rising interest rates, that shouldn't be your focus to begin with. If you're a growth investor, look elsewhere.
But for income investors, who presumably make up the bulk of those who buy utility stocks, those dividends should keep rolling in. Each of these three utilities yields between 4%-5%, which is far better than most fixed income securities. From that perspective, utilities will continue to do what they're supposed to do.