A brave new era for Utilities

Jeff Rottinghaus, Portfolio Manager,
US Equity Fund

Key insights

  • Utilities offer investors potentially appealing growth opportunities with dividend yields that also remain attractive.
  • A steady decline in renewable energy costs is transforming the utility sector, lowering operating expenses and fuelling faster earnings growth.
  • We believe utilities now have the potential to provide returns comparable with the broad US equity market and with less volatility, which could raise valuations.

The rise of renewable energy is transforming the utilities industry

When you think about classic defensive areas of the equity market, the utilities sector likely springs to mind – traditionally offering low volatility returns, relatively insulated from the vagaries of the economic cycle, but also little in the way of earnings growth.

However, industry dynamics are changing, to the extent that this conventional view of the utilities sector is looking increasingly outdated. In fact, we believe utilities today could provide some of the best long term, risk adjusted, return opportunities of any US equity market sector.

A new era

Historically, utility returns were driven almost entirely by dividend yields and these were, in turn, highly correlated with yields available on US Treasury and corporate bonds. For investors looking for growth, the utilities sector was not the place to be.

During the period from 1986 to 1998, for example, earnings growth for companies in the S&P 500 Utilities Index was effectively flat. In comparison, earnings for companies in the broad S&P 500 Index rose 159%, or at an 8.5% compound annual growth rate (CAGR).

More recently, however, this picture has changed markedly. Utility company earnings growth has accelerated, while earnings growth for the broad market has slowed – narrowing the earnings gap considerably. Over the decade ended 2017, for example, earnings per share for the S&P 500 Utilities Index grew at a 4.1% CAGR, compared with 6.1% for the S&P 500 (See Fig. 1) .

However, industry dynamics are changing, to the extent that this conventional view of the utilities sector is looking increasingly outdated. In fact, we believe utilities today could provide some of the best long term, risk adjusted, return opportunities of any US equity market sector.

The new era for utility companies is being driven by several significant developments, including:

Low-cost renewables are transforming the industry

These durable trends, especially the shift toward renewables, have put downward pressure on fuel, operating, and maintenance, costs enabling utilities to increase rates of return without driving up customer bills. And while the gap in earnings growth has narrowed considerably already, we believe aggregate earnings growth for the S&P Utilities Index could exceed that of the S&P 500 Index within the next few years.

Disruptive change is benefiting the sector

Among those sectors traditionally considered more defensive – i.e. those that, historically, have been relatively less aligned to the economic cycle – the utilities sector is the only one, in our view, that is not threatened by significant secular risks, such as the emergence of new competitive forces or technological innovation that would undermine topline growth and profit margins. While telecoms, consumer staples, and parts of health care, all face secular challenges of one form or another, utilities are, in fact, benefiting from industry-disruptive change.

The landscape is not without risks

There are some risks to the utilities value proposition – challenges that could potentially undermine our expectations for the sector. We remain mindful of potential risks, such as:

  • Regulatory limits on fracking, or an outright ban on fracking on public lands, could lead to higher natural gas prices and customer bills.

  • Regulation is still a challenge in some states, notably California, Arizona and, more recently, Texas. A primary focus of our research into specific utility companies is understanding, in detail, the regulatory environment in the state/s where they primarily do business.

  • A significant increase in US inflation and/or interest rates could put pressure on company operating costs and customer bills.

  • At a market level, the utility sector is no longer as out of favor as it was several years ago, and valuations become elevated.

On balance, we believe the utility sector’s improving dynamics offer an attractive opportunity for long-term investors seeking growth potential with moderate risk. The emergence of low-cost renewables could pave the way for a sustainable, multi-decade, period in which utilities can potentially deliver above-trend earnings growth, while continuing to offer relatively attractive dividend yields.

The shift toward renewables [has] put downward pressure on fuel, operating, and maintenance, costs enabling utilities to increase rates of return without driving up customer bills.


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