Stock Market Sectors: The ‘Utility’ of Strong Stable Profits

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So far, we’ve seen several sectors that, while including a diversity of industries, are usefully grouped according to shared sensitivity to macroeconomic dynamics. Sectors like consumer staples provide stable cash flow at the expense of the explosive upside of sectors like finance and energy.

Today, we’ll be examining the dynamics associated with Utilities, a unique and highly regulated sector. While utilities tilt strongly toward dividends and stability over growth potential, new technologies can still create unpredictable (and profitable, for news-based traders) disruptions. And, with some exposure to more volatile global variables like energy prices, the utility sector still has a cyclical element we need to understand.

Utility Sector Basics: Electricity, Gas, Water

This sector includes all non-telecom utility service providers, including electric companies, natural gas companies, and water utilities. In general, these companies make money on a fee-for-service model. often, more of these fees go to support dividends and debt than for operations themselves. In this sense, utility companies are not just proxies for efficient service delivery, but for the long-term infrastructural capital of a defined geographic region. With many utilities possessing a de facto monopoly, their rates are, in general, highly regulated. These regulations are generally managed to offer the utility in question coverage for operational costs plus some profit margin. Future returns for these stocks, then, are nearly locked in—almost like a bond.

Still, the utility sector has more risks than many investors realize. The sizable infrastructure required by utilities’ business models is expensive to build and maintain. Consequently, firms in this sector tend to bear substantial debt loads, rendering them vulnerable to sudden shifts in interest rates. Concurrently, utility firms expected to maintain substantial dividend payments. These dual demands can lead to a near-permanent cash-crunch. But limited cash reserves—so long as there’s a stable business model and extra profits are headed to investors—can still be the basis of a lucrative investment.  Meanwhile, pollution and, increasingly, carbon regulations drive a continued need for newer, more expensive equipment for utility providers, another source of liquidity pressure for this sector in today’s market environment.

Consequently, the balance sheet should be a first stop when evaluating a potential play in this sector. Heavy debt loads can be particularly cumbersome for utilities: with no method for substantially growing revenues, news debt goes hand in hand with a worsened credit rating and more expensive lending. Poorly managed finances can quickly lead to a self-defeating cycle.

Strategic Dynamics

Traditionally, we might expect utilities to compete with non-equity financial instruments like bonds: both provide stable returns and relatively low risk. Since the Great Recession of 2008, however, low interest rates have driven the returns on bonds down. Rates have been inching back up during the current bull market, but the dividend yield on utilities remains uniquely attractive relative to Treasuries and the dividends offered by other sectors. Safe, stable cash flow may sound boring, but in today’s low-interest rate environment, it has more value than ever.

No cash stream is free from competition, however. Decentralized generation technologies like solar panels will pose a profound challenge to traditional utilities in the coming years. And the producers of these technologies may not even come from this sector!

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