How can you know which utilities are good investments? Following is a list of characteristics to examine when evaluating a utility company for your dividend portfolio:
Dividend performance: In most cases, you don’t realize big returns from share price appreciation, so make sure the utility has been increasing its dividend payouts regularly over the last four to five years. Don’t worry about cuts that happened at least five years ago if dividends have been growing since then, but make sure you understand the reasons for them. Were they due to poor investments, excessive debt, or poor relations with regulators? Recent cutbacks in dividends are enough to knock them out of a portfolio. If it’s a small cut, you may want to stay, but for a lot of investors a dividend cut is a deal breaker. Who knows when it will come back? If it doesn’t, you’re left with a stock with low expectations for share price appreciation. Sell these shares and put the cash into a firm with a growing dividend.
A focused business: Utilities with nonutility businesses are riskier than pure utilities. These outside operations have the potential to divert capital away from dividends, hurting yields. When you look at the company’s earnings press release or annual report, look for income and investment details broken out by separate units of the corporation. These units may be subsidiaries or company units involved in completely different businesses. As a dividend investor, stick with pure utilities.
Regulatory environment: Some states have tighter regulations than others, and others, such as Texas, are more pro-business. States with laissez-faire attitudes about keeping rates affordable for customers tend to allow utilities to charge higher rates — bad for consumers, but good for shareholders. Florida, Texas, and California are utility-investor-friendly states. Do some research on the Internet to find out which other states fall into this category. Just go to a search engine and type in the type of utility (such as “electric”), the name of the state, and the words “regulatory atmosphere.” The results should bring up the kind of information you need.
Although it often gets a negative rap, deregulation isn’t necessarily bad. Because deregulation hasn’t had its intended effects, utilities in a position to take advantage and charge more when supply is short post higher profits. This action may sound shady to customers, but it’s good for shareholders.
Debt load: Utilities often carry large amounts of debt because they own significant infrastructure that requires a lot of upkeep and upgrading. Typically, their liabilities are larger than their assets, but debt higher than 60 percent of total capital should be a red flag. These high debt loads make utilities extremely sensitive to fluctuations in interest rates — as interest rates rise and fall, so do the debt payments. Therefore, utilities perform best when interest rates are falling or remain low.
Very high yields: Be wary of utilities with yields significantly higher than the sector average. High yields mean the company may be shelling out more than 80 percent of its profits, or the stock has been pushed very low. A low stock price may just be due to a broad bear market, but it may point to fundamental problems in the business. In addition, high dividend payouts may cause regulators to get tougher on the company and lower its rates, which can lead to a dividend cut.