Utilities Have Outperformed, but Staying Power Isn’t Certain

The S&P 500 Utilities index has climbed 4% year to date, compared with a 19% slide for the S&P 500 overall.

Utility stocks have creamed the market as a whole in 2022.

The S&P 500 Utilities index has gained 4% this year, compared with a 19% loss for the S&P 500 overall.

Utility stocks have benefited as investors search for stability and yield amid a volatile market. That has allowed these stocks to overcome the negatives of soaring inflation and interest rates.

Rising inflation hurts utilities because regulators often won’t let them raise their prices to match their surging costs. Higher rates hurt utilities because they make their dividend yields less competitive with bond returns. 

Further, higher interest rates lift utilities’ borrowing costs. These businesses often have to borrow a lot of money to finance their projects.

But the stability factor has outweighed the negatives.

In addition, new clean-energy-investment opportunities will enable utility companies to expand over the next decade, 

Morningstar senior equity analyst Travis Miller said in a commentary. “There is better long-term growth in the industry now than ever before.”

Now, …

Clean Energy Incentives

The federal government, through the Inflation Reduction Act, and state governments have created incentives for more clean-energy investment. Next year “looks like it’ll be a pretty robust year of solar and wind growth,” Miller said.

All the enthusiasm for utility stocks has made that sector the most overvalued in the market, according to Morningstar analysts. 

As of Sept. 15, the utility sector traded at an 8% premium over Morningstar analysts’ fair-value estimates. The analysts cover 37 stocks.

Xcel Energy  (XEL) – Get Xcel Energy Inc. Report and CMS Energy  (CMS) – Get CMS Energy Corporation Report were the most overvalued, at 26%. Only one utility stock was undervalued — NiSource  (NI) – Get NiSource Inc Report, with a discount of 9%.

“I’m not surprised they’ve gotten expensive, but I would not be surprised if they get even more expensive,” Raheel Siddiqui, senior research analyst at Neuberger Berman, told Morningstar.

“In periods of economic downturns, it is common for utility stocks to become even more expensive as investors covet their stability.” 

Many experts anticipate a recession later this year or next year.

Historical Returns

Utility stocks have generated an annualized total return of 8.97% over the past 30 years, almost matching the broader market’s 9.8%, Morningstar noted.

But Miller pointed out that inflation was never as high during that period as it is now — exceeding 8% — and rates weren’t rising as rapidly.

“Interest rates and inflation hit utilities on a more fundamental basis than they do other companies,” Miller said. 

“It’s unusual relative to past history that utilities would be the second best-performing sector when you have sky-high inflation and interest rates [rising].”

He sees ascending inflation and rates as “long-term risks for the sector.” And that “suggests we’re going to see lower returns in the sector than we have seen in the past.”

So now may not be the time to go all in on utilities.

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