There's a good chance you got into the stock market for the opportunity to invest in exciting companies that can change the world and make you rich in the process. Utilities are not that opportunity.
But they can be a beautifully boring investment that can produce stable returns over time while also helping you sleep at night. And for a lot of folks, that's a smooth road that can lead toward achieving financial goals.
The utility sector has missed out on the market rally this year and is currently hovering around a two-year low. The sell-off has pushed the yield of the Utilities Select Sector SPDR Fund(NYSEMKT: XLU) up to 3.1%. Here's why it's the best utilities exchange-traded fund (ETF) to buy now.
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The market dynamics of utility stocks
The Utilities Select Sector SPDR Fund tracks the performance of the broader utility sector. As of Sept. 1, utilities made up just 2.4% of the SPDR S&P 500 ETF Trust(NYSEMKT: SPY), the largest ETF by assets under management. S&P 500 index fund investors are getting very little exposure to utilities. And for good reason.
Utilities are low-growth businesses that are weakly correlated to the broader economy. So investors who are still in the asset accumulation phase of their lives might not want too much exposure to utilities. But there are a lot of unique advantages for risk-averse investors, folks looking for supplemental income in retirement, or anyone who likes passive income.
Since utilities provide basic needs (and many are regulated), they can be uniquely stable investments. During a recession, investors tend to gravitate toward companies that have consistent demand for products and services no matter the market cycle. Utilities, along with healthcare and consumer staples, are some of the safest sectors out there.
But the utility ETF has a 3.1% yield, which is higher than 1.6% for healthcare and 2.5% for consumer staples. In fact, it is the third highest-yielding ETF behind energy and real estate, which both yield 3.7% but are far more cyclical and volatile.
All told, the utility sector is the single best place for investors looking to blend safety and a high yield.
Dissecting the ETF
A total of 58.6% of the ETF is concentrated in 10 holdings, most of which are regulated electric utilities. Notice that most of the holdings have a forward price-to-earnings (P/E) ratio under 20, which is an important level because it is the current forward P/E of the S&P 500.
Company | Industry | Weight | Forward P/E Ratio |
|---|---|---|---|
NextEra Energy(NYSE: NEE) | Regulated electric utility | 14.8% | 21.2 |
Southern Company(NYSE: SO) | Regulated electric utility | 8% | 18.4 |
Duke Energy(NYSE: DUK) | Regulated electric utility | 7.4% | 15.4 |
Sempra(NYSE: SRE) | Diversified utility | 4.8% | 15.4 |
Dominion Energy(NYSE: D) | Regulated electric utility | 4.4% | 13.7 |
American Electric Power(NASDAQ: AEP) | Regulated electric utility | 4.4% | 14.4 |
Exelon | Regulated electric utility | 4.3% | 16.8 |
Constellation Energy(NASDAQ: CEG) | Renewable utility | 3.8% | 21.8 |
Xcel Energy(NASDAQ: XEL) | Regulated electric utility | 3.4% | 16.6 |
Consolidated Edison(NYSE: ED) | Regulated electric utility | 3.3% | 17.7 |
Data sources: State Street Global Advisors, YCharts, Yahoo! Finance.
Many of these companies own smaller regional utilities. Or you might know some of their holdings under different names.
For example, if you live in Florida, you're probably familiar with Florida Power & Light, which is owned by NextEra Energy. Exelon owns Atlantic City Electric (New Jersey), Commonwealth Edison (Illinois), PECO Energy Company (Pennsylvania), Baltimore Gas and Electric (Maryland), Delmarva Power (Delaware and Maryland), and Pepco (Washington, D.C., and Maryland).
If you were to lay out these companies' assets on a map, they would make up a large swath of the U.S. power grid.
Utilities and the energy transition
Regulated electric utilities work with government agencies to set prices and turn a profit without taking advantage of their monopolies over customers. Utilities can grow in a variety of ways. The simplest is increased power use, which can come from a rising population. Another area of growth is renewable energy.
Many utilities are investing in renewable energy to help states and the U.S. as a whole reach carbon reduction goals. Wall Street rewarded NextEra Energy for being ahead of the curve and successfully converting a large share of its power generation away from coal and natural gas toward solar and wind. That's why it is the most valuable utility and the top holding of the ETF. The stock is up 231% over the last 10 years, beating the performance of the S&P 500.
Aside from its regulated electric utility business, NextEra Energy owns NextEra Energy Resources, which operates solar and wind projects across the United States, not just in Florida. In this way, the business benefits from a growing renewable energy business.
But it remains to be seen how the broader industry will execute the transition to renewables. Each region has its own challenges. And some states are better suited for certain types of renewable energy than others, not to mention different regulations and permitting processes.
Investing in a utility ETF instead of a single utility is the easiest way to avoid the risks that come with betting on a single company. For utilities especially, this strategy makes a lot of sense because it avoids the risk of geographic concentration that would come with picking a single regional utility company.
A passive-income powerhouse
Utilities generate stable profits and have predictable cash flows that support consistent dividend increases. They might not have the growth potential to be great stocks from a capital gains perspective. However, the utility sector should gradually grow in value over time.
The Utilities Select Sector SPDR Fund has an expense ratio of just 0.1%, making it an extremely inexpensive way to gain exposure to the top utility stocks.
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Daniel Foelber has the following options: long October 2023 $45 calls on Dominion Energy. The Motley Fool recommends Constellation Energy, Dominion Energy, Duke Energy, and NextEra Energy. The Motley Fool has a disclosure policy.
