For many investors, utility stocks are seen as safe havens because the products and services they provide are considered necessities. Although utilities typically do not offer huge growth potential, a slow and steady income producer can be a desirable investment option for conservative types and those seeking calmer waters in an otherwise turbulent stock market.

That said, utility stocks are available in a broad spectrum of investment options and require more than just a surface look if you want to find the right opportunities for you. Here's a primer on how to invest in utilities that should get you sailing in the right direction.

What is a utility?

"Utility" simply means "the state of being useful." That's a pretty good way to describe utility stocks, which generally provide customers with things like water, gas, and electricity that help them live their everyday lives in comfort. Suffer through a long blackout and you'll quickly understand how "useful" power is. Flush a toilet in your home and you'll see the usefulness of clean, reliable water and sewer services. But there's more to this sector.

A man working on an electric power pole

Image source: Getty Images

A defining feature of utilities is that they generally have monopolies in the areas they serve because it would be cost-prohibitive to build two competing companies. There are huge expenses involved in building and maintaining a power plant, the extensive grid network to move power to customers, and the financial and customer-service systems needed to deal with thousands, if not millions, of users.

The end result is that, if you want electricity, you generally have just one provider. The upside for investors here is that an economic downturn is unlikely to lead to a material decline in business since customers have no other options.

But there's a trade-off since an unchecked monopoly would allow a company to potentially institute abusive price increases. To prevent this, government entities generally regulate utilities, requiring proof that rate increases are needed before allowing them. Not all utilities or business operations within a utility company are regulated, but a significant number are in some way under government oversight. 

What kinds of utilities are there?

The first type of utility that most investors think about is electric. These companies generate and/or distribute electric power. There are also natural gas utilities, which distribute gas to customers directly or use gas to fuel electricity-generating power plants. Most natural gas utilities do not actually "make" gas; they usually buy it from oil and natural gas drillers, taking delivery through bulk pipelines, then distributing it through the smaller systems they build and maintain in local markets. While electric and natural gas utilities are focused around the need for power, water utilities maintain the systems that provide clean water to customers and collect dirty water after it has been used. These are all products and services that are very hard to live without.

It is worth noting that telephone and cable companies were once considered utilities. But changing technology has shifted the competitive environment, and telephone and cable companies have largely been moved into the communications sector. This new sector has a lot of overlap with the technology sector as well. While some parts of telecom and cable businesses remain regulated, the companies involved offer services that don't really live up to the idea of providing an essential product or service that customers can't live without anymore. 

What are regulated utilities and nonregulated utilities?

The idea of regulation is important in the utility space, as it provides both protection from competition and a limit on unfettered pricing power. But not all utilities and divisions within a utility are regulated. For example, many electric utilities have both a regulated business and a nonregulated (or merchant power) business.

The regulated businesses will generally make and sell power to individual customers and businesses and have a monopoly in a given service area. In exchange for that monopoly, the utility must answer to regulators that approve (or reject) any requests for rate hikes. These requests are generally backed by spending needs to maintain and upgrade utility systems. 

The nonregulated operations generally create power and then sell it to other utilities. The price of that power is set using spot rates, which are dictated by electricity demand, or under long-term contracts. The latter is a far more stable business, since the demand for electricity fluctuates with the time of day, the time of the year, and weather patterns (which are completely unpredictable). 

There are also other business segments that can find their way into a utility that may be regulated or nonregulated, such as long-haul natural gas pipelines and high-voltage power lines. Assets like these need to be examined separately because there are different dynamics involved. For example, a large natural gas pipeline may be regulated at the federal level, and its customers will usually be a small number of utilities and/or energy exporters. That's a very different operation from delivering natural gas to thousands (or millions) of individual customers.

Electric utilities aren't the only ones that delve into other areas. For example, water utilities often operate systems for military facilities. These are regulated in that they need approval from the military for rate changes, but they aren't the same as owning a water utility since the military owns the water system and simply hires (usually under a long-term contract) the company to operate it. 

How does utility regulation work?

Utility regulation is a complex topic. But the basic idea is that the local, regional, and/or federal government oversees a utility. They monitor things like reliability, spending plans, regional growth rates, and the rates that customers pay. The goal is to balance the need for investors to receive an adequate return on their investment (which varies over time and by region) and what are deemed to be fair rates for consumers. Generally speaking, if no factors change, there's little reason to justify price increases.

Of course, there are always things that change, even if it is just upgrading or maintaining outdated equipment. Normally, there are notable investments that need to be made in equipment, in new power production assets, and in quality improvements (such as fortifying systems against storm damage). Utilities present their investment plans to the regulators to review and, hopefully, approve requests for rate changes.

The regulatory environment within which a utility operates can be very important to its future results. If the relationship with regulators is contentious, a utility will likely have a hard time getting rate changes approved. If the relationship is generally positive, rate issues will be easier to tackle. 

Regulated utilities have to spend money to grow their businesses -- just like any other company. But that spending has to be cleared through regulators. So while a regulated utility may have a monopoly and a highly reliable business, that's not a guarantee of long-term success. 

How do nonregulated merchant power companies operate?

Nonregulated assets work differently. Let's say a utility builds a power plant with the goal of selling the power it generates to others. A conservative approach would be to sell power under long-term contracts. This produces fairly predictable income and is a relatively safe business.

The more aggressive tack is to sell electricity on the spot market. There is no specific customer, per se, and power will only get bought when it is needed, which in some cases won't be very often. These so-called "peaking plants" are meant to supply power only during demand spikes. That may not sound like a great business, but energy prices can get very high for short periods of time and create profit opportunities for companies that have the energy available when the demand requires it.

Like regulated operations, the nonregulated business grows through capital spending. But there's less oversight on what gets built and how it is used. A company could build a power plant and find that it never gets used, which is why conservative utilities prefer to ink long-term contracts for the power that nonregulated assets generate. The rates for nonregulated operations are contractually based and decided between the two parties. That can cause trouble on either side of the agreement, since a rise or fall in power prices could end up hurting one side or the other. The buyer is more likely to feel the pain of falling prices, since the owner of the asset would, presumably, not sign an undesirable deal unless it had no other choice. The seller is inclined to make a deal, since letting a costly energy asset sit idle would not be a great business decision. 

Can utilities own any other assets and businesses?

Utilities also frequently own other assets, like the natural gas pipelines and high voltage power lines already mentioned. There is often regulation in these spaces as well, but it takes a different form. Natural gas pipelines, for example, are often regulated at the federal level and not locally. The prices that utilities charge customers for the use of these midstream assets is often contractually based. And, like merchant power operations, these businesses generally grow by building new assets. 

That said, utilities aren't confined to any particular set of assets. For example, the utility Hawaiian Electric Industries famously owned one of the largest banks in Hawaii for many years. Although it eventually spun that off, this anomaly shouldn't be ignored. A utility could easily venture into areas that don't fit well with its core business and end up affecting shareholder value. It's important to think about this as you look at utilities you might want to invest in. 

Can other businesses own utilities?

Recently there's been an interesting trend in the oil industry, with oil companies Royal Dutch Shell and Total buying utility assets. The logic here is that the companies are diversifying their businesses into an area that is expected to see increased demand. That, they hope, will protect them as demand for fossil fuels like oil shifts to demand for renewable energy like wind or solar. These companies are still largely oil companies, so they don't really fall into the utility space. However, as the trends toward renewable power and electrification continue to gain steam, look for more non-utilities to invest in utilities.

Do utilities buy other utilities?

Like most sectors, utilities can increase their scale quickly by buying other utilities. They face all the issues that a typical company would during an acquisition (like getting shareholder approval). But there's more red tape involved with utilities related to regulatory approval for mergers. This can be more problematic than it sounds, because regulators in every separate region that the utility operates in have a say, and they all have to give their approval before a deal can be done. Some utility mergers can take a year or more to complete, and tense regulatory relationships can doom a merger.

What are the key operating factors to look at when researching a utility?

There's no one factor that dominates when looking for a utility to invest in. Several factors come into play, and you occasionally need to balance them against one another. Few companies, let alone utilities, are perfect investment choices. Because of that, here are six factors to keep in mind when considering a utility to invest in:

1. Understand what the utility does

It could be as simple as "it's an electric utility with operations in just one state." Or it could be far more complex, with both electric and natural gas operations in multiple states. It may also own assets that are outside the typical utility space, like midstream pipelines or natural gas export facilities. You could also be looking at a company that isn't regulated, like a merchant power company, which changes the risk equation a great deal.

2. Understand the types of assets it owns

Once you figure out what the utility does, then look at the underlying assets. Electric utilities, for example, have generating assets and distribution assets. On the generating side, you'll want to know the fuel sources involved, which can include coal, natural gas, solar, wind, hydroelectric, and nuclear. Less common fuel sources are biomass (burning trash or wood) and oil.

There are different dynamics involved with each fuel. Coal has fallen out of favor because of its environmental issues, with natural gas largely displacing it because of lower costs. Solar and wind facilities are increasingly being built and currently look like the future of energy. Most of the good hydroelectric locations, which require ample flowing water, have already been developed.

Distribution assets like pipelines also need to be examined as above-ground and below-ground pipes have different installation and maintenance costs as well as whether the pipes are protected against weather issues like hurricanes. Water utilities are important to examine, too, since clean water and wastewater are very different businesses. 

3. Understand the regions in which a utility operates

Different regions of the country have very different dynamics associated with them. In the Northeast, heating in the winter is a big issue, as is cooling in the summer. In the South, cooling will generally be the bigger concern. California is very dry and wildfires can cause major headaches for utilities. Simple things like regional weather patterns can actually play a large role in the way earnings unfold throughout the year. 

You'll also want to consider access to fuel. The Northeast is currently facing supply constraints for natural gas because there aren't enough pipelines to provide all the gas needed during peak periods. That can lead to price spikes and supply shortages, and could even result in blackouts. Location can also affect renewable power options, with windy regions more likely to invest in wind turbines and sunny regions in solar cells. The effects on the bottom line can be small, but they can also make a huge difference in earnings performance.

4. Understand the regulatory market

Regulators, as already noted, play a big role in the utility space. Therefore, it's worth the effort to get a read on the type of relationship a utility has with its regulators. Look to see how quickly rate-change cases unfold (delays and pushback are generally a bad sign) and how close the regulators' final decision gets to the utility's original rate change requests (big differences aren't usually a good sign). And always watch the list of upcoming rate requests, since they will be a big determinant of future earnings even though they also can lead to uncertainty on the top and bottom lines. 

5. Understand how a utility gets paid

You might say the answer here is that customers get a bill and then pay it. But what this actually refers to is the need to know whether a utility is passing the costs of electricity through to customers or choosing to get paid for the use of its transmission assets. Utilities that focus on transmission could be better positioned over the long term since power generation is more in flux these days. Renewable sources, often owned by third parties, are gaining scale quickly within the industry.

6. Understand a utility's growth potential

As it relates to growth, there are a couple of different angles to consider. First, in reference to the regions in which a utility operates, you'll want to know if the population is growing or shrinking. A growing population means more customers and is preferable. 

Second is to consider the status of the infrastructure in place. Will infrastructure replacement be a big investment? Water utilities often buy assets from municipalities that haven't invested enough money in maintaining their water systems. That means that there can be years of upgrades that need to be financed, all of which the water utility can use to support higher rate cases. Natural gas distribution systems are also frequently in need of repair. Electric utilities, meanwhile, may need to upgrade their distribution systems to protect them from severe weather or replace aging power plants. These factors can be used to justify rate changes. Utilities often lay out their spending plans well in advance, allowing you to get a handle on just how important all of these factors are to the business. 

What are the key factors to consider when looking at a utility stock?

Once you have a better handle on the utility you are looking at, your next step is to take a closer look at the financials. It's important to remember that a good company may or may not be a good investment. You don't want to overpay or end up buying a financially distressed name. Here are five financial metrics that apply to utility stocks:

1. Examine the dividend

For better or worse, most investors look to utilities as income investments. That makes sense given the regulated nature of these businesses and the fact that many pay sizable dividends. Is the dividend yield enough for you? That's something only you can answer, but setting a minimum acceptable percentage can help narrow your choices. And what is the yield versus historical levels? For example, NextEra Energy's (NYSE:NEE) dividend yield in 2019 is near historical lows for the company. That suggests that the stock may be expensive. You might also want to look at yield compared with the average utility, which is roughly around 2.9% using the Vanguard Utilities Index Fund ETF (NYSEMKT:VPU) as a proxy. A higher- or lower-than-average yield might raise additional questions. 

Also related to the dividend is the payout ratio, which compares the dividend with earnings. If a utility's dividend is eating up too much of its quarterly earnings, then the dividend could be at risk of being cut. The average payout ratio for the industry, at least on the regulated side, is currently around 70%. That would be high for a typical company, but the nature of how a utility operates allows for this level without too much trouble. Too much higher, though, and investors should be cautious. 

Another issue to watch is a utility's commitment to the dividend. For example, Southern Company (NYSE:SO) has increased its dividend or held it steady for 71 consecutive years. That's a pretty incredible record, but Southern is hardly alone in its dedication to rewarding investors. This is not a guarantee that a dividend will be maintained in the face of trouble, but it does provide a little insight into management's thinking about the sanctity of the payout. A solid dividend history clearly connotes a company that has a stable and growing business. 

2. Look at the balance sheet

Another important thing to examine is the utility's balance sheet. Utilities tend to be heavy users of debt, largely because of their regulated nature and the high initial cost to build and maintain their income-generating assets. There are no pre-set targets to suggest here, but less leverage is generally better, and figures like debt-to-equity and debt-to-EBITDA metrics can help when comparing investment choices. 

It's also worth looking up a company's credit rating. This will give you a third-party assessment of the company's financial strength. Again, stronger is usually better, with an investment-grade rating the clear goal for more-conservative investors. 

3. Growth and investment plans

Most utilities will provide long-term estimates of what they want to spend and what it will likely be spent on (broadly speaking). Most investors won't be able to see the full plan details, but you should have enough information to gauge if the company's plan makes sense. As part of that analysis, you'll want to look at the projected impact on financial results and, equally important, if the utility looks financially strong enough to carry out the plans. 

In addition, keep an eye on execution. Big plans are great, but only if a company has a strong history of delivering on its promises. To be fair, it isn't unusual for big projects to get delayed and run over budget. However, these are the types of things that can cause tension with regulators and result in big one-time charges for investors. 

4. Don't forget about stock valuation

Although stock valuation was hinted at in the dividend discussion, there is more to consider. For example, a company's price-to-earnings ratio can be a good measurement tool for utilities. In general, utilities are not growth stocks, so P/E ratios will tend to be at the low end of the broader market. But that doesn't mean there isn't great variation within the peer group. NextEra's P/E is around 30, while its peers Duke Energy (NYSE:DUK) and Southern Company have P/E ratios of around 20 and 13, respectively. Clearly, there are valuation differences here that need further examination.

5. Compare apples to apples (most of the time)

Remember that there are different kinds of utilities. Comparing a water utility with an electric utility doesn't make a lot of sense. Neither does comparing a largely regulated utility with a nonregulated power company that sells electricity only in the highly volatile merchant market. So make sure you understand the businesses you are looking at and make appropriate comparisons. 

That said, it might make sense to look at a regulated utility versus a nonregulated utility from a top-level view, considering which type would better fit in your portfolio.

What are some utility stocks to look at right now?

NextEra Energy has been mentioned a few times in this report. The stock is hardly cheap today, but it is one of the best-run utilities in the United States. Its 12% to 14% dividend growth outlook for 2019 and 2020 is easily at the top end of the industry, backed by robust capital spending plans ($12 billion to $14 billion a year through 2022) and a modest payout ratio. With some of the lowest customer costs in the nation, it also happens to have a pretty strong relationship with its regulators. While it's not cheap, investors looking for dividend growth would do well to consider it. Just know that you are paying up for that dividend growth. 

Investors seeking a high yield, meanwhile, might want to look at Southern Company and its 4.3% yield. That's toward the high end of the industry but it's backed by a long-standing commitment (70-plus years) to stable or rising dividends. That said, Southern is in the middle of building a nuclear power plant that's delayed and over budget. It looks like the project is getting back on track, but investors still have a show-me attitude to the company. Note, too, that this investment has left Southern with a debt-heavy balance sheet. There's more operational risk here, but if you can stomach a little uncertainty, the yield may be worth it.

For those with an environmental focus, you might want to look at Brookfield Renewable Partners (NYSE:BEP). This limited partnership owns hydroelectric, solar, and wind power assets, selling power under long-term contracts to utilities. It's a bit different from the two names noted above, but it offers a 5.5% dividend yield and is keyed in on an increasingly important niche in the utility industry. Managed by Brookfield Asset Management, Brookfield Renewable Partners has positioned itself as a leader in renewable power that's worth a close look from both income investors and even those with a more growth-oriented view of investing. 

American Water Works (NYSE:AWK) is one of the largest public water utilities and is a good starting point for investors interested in that space. The company believes it can grow earnings between 7% and 10% a year through 2023 with a combination of investments in its regulated assets (largely for upgrading old pipes and such), bolt-on acquisitions, and ongoing growth in its nonregulated business (like running-water systems for the military). That, in turn, should support dividend growth of 7% to 10%, which is notable for a utility. That said, like NextEra, investors are well aware of the dividend growth prospects here and have bid the shares up accordingly. The yield is a miserly 1.6%, and only investors focused on dividend growth should really be looking here. 

For those seeking a natural gas play, it might make sense to venture beyond the utility space into midstream limited partnerships. Right now, industry bellwether Enterprise Products Partners (NYSE:EPD) is offering a robust 6% yield with operations that are largely fee-based and tied to long-term contracts. (The partnership, by the way, answers to federal regulators.) Meanwhile, its business spans the pipeline, storage, terminal, and transportation spaces, with a material emphasis on natural gas, providing a level of diversification that few peers can match. And it has a long history of operating in a fiscally prudent manner, noting that debt to EBITDA is toward the low end of its peer group and its distribution coverage is easily among the strongest in the space.  

The ETF punt

If you'd rather not buy individual stocks, you can still invest in the utility space without too much hassle by adding an exchange-traded fund (ETF) to your portfolio. ETFs generally track an index of stocks, essentially providing investors broad exposure to entire sectors (or even the entire market, depending on the index being tracked). They trade all day just like a stock and pass any dividends on to investors after management fees, which tend to be very low, are taken out. It's a great way to get exposure to a sector without having to dig too deep into that sector.

Some good options here include Vanguard Utilities Index ETF, which we used earlier as a proxy for the industry. It has an expense ratio of just 0.10%, owns 59 utility stocks, and provides notable exposure to electric utilities (roughly 56% of assets) and diversified utilities (30%), which generally own a mix of electric and natural gas assets. The yield is roughly 2.9%. Another strong option is Utilities Select SPDR ETF (NYSEMKT:XLU). It is a little more expensive to own, with a 0.13% expense ratio, but it offers a higher yield, at roughly 3.1%. That said, the biggest selling point might be that the ETF tracks the utilities sector within the S&P 500 Index -- which itself is a curated stock list intended to be a broad representation of the U.S. economy. Again, electric (61%) and diversified (roughly 33%) utilities are the bulk of the portfolio.

Investors interested in yield, meanwhile, might want to look at Alerian MLP ETF (NYSEMKT:AMLP), which offers a huge 8% yield by tracking a collection of midstream energy partnerships (including Enterprise Products Partners). That said, it also charges a stiff 0.85% management fee and has a history of being pretty volatile. It's not for the faint of heart, but if you are fond of income, it is at least worth looking at.   

Not exciting, but dependable

When all is said and done, utilities are often seen as a boring niche within the broader market. And that may be true since a big portion of their return for investors has historically come from dividends. But when you include those dividends in return (looking at the total return as opposed to simply stock price change), utilities start to look a lot more exciting. Note, for example, how the utilities in the chart below kept up with and, in some cases, even exceeded the total return of the broader market over the past decade.

SPY Chart

SPY data by YCharts

If you can see past the day-to-day price movements in the market and look at the big picture, including both diversification and income, utility investments can be a great addition to your portfolio. No, they won't be all that exciting to own, but that's the point.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.