When people think of income-producing stocks, the industry group that typically comes to mind first is utilities — electricity, gas, and water, to name a few. For dividend investors, utilities are attractive because many offer stability and premium yields — the holy grail of dividends.
Utilities are a category of companies that provide the services and power necessary to run buildings and make modern life possible. Given their propensity to pay out 60 to 80 percent of their average annual earnings as dividends, utilities are some of the highest-yielding stocks in the entire stock market.
Defining utilities
The three main classes of utilities are
Electric companies are responsible for the generation, transmission, and distribution of electrical power. Integrated utilities provide all these functions under one roof. Generation can involve a variety of sources, including gas, nuclear energy, solar power, and wind power, but the majority of America’s electricity comes from burning coal. Transmission and distribution rely on power grids and power lines. Although generation and transmission can come from two separate companies, both fall into the utilities category. Many states have deregulated their electricity markets.
Natural gas companies provide the energy to heat homes and supply cooking gas. They’re often aligned with electric companies because gas can be used to produce electricity. Most natural gas companies remain monopolies, which means that these companies almost always earn a profit and pay dividends but also that they can be subjected to heavy regulation. The following section covers the effects of monopolies and regulation on utilities in greater detail.
Water companies are responsible for distributing fresh water throughout communities, piping it into buildings, and removing sewage. Most water companies are owned or run by the local municipalities. However, water supplies are running scarce in parts of the country and the world. Supplies are expected to tighten, providing earnings growth potential as demand exceeds supply.
Appreciating utilities’ income-generating capabilities
Here are a few reasons utilities traditionally have been good income-producers:
They’re monopolies with no competition. Building power plants and infrastructure requires huge capital investments, and it is neither practical nor desirable to have numerous power grids or sewage systems overlapping each other. The huge capital requirements create a big barrier to other firms entering the business; few companies would commit so much money without some assurance they’d receive a return on their investment.
Government-set rates ensure a reasonable profit. Regulators need to balance the competing interests of shareholders with the needs of consumers. Although customers need rates to remain affordable, the utility must remain profitable to stay in business. To achieve this balance, the government sets what it deems a reasonable profit to provide the company and its investors with a sufficient rate of return. The regulators then add in all the company’s expenses to arrive at a necessary level of sales. According to the number of customers and their usages, regulators set a base rate to produce the desired revenues, and thus, profit.
They rarely go out of business. Utilities have a large captive clientele. Nearly every citizen and business needs to use their services. If a customer doesn’t want to get cut off from the utility’s services, she has to pay the bill, which means utilities can count on consistent revenues and cash flow. Unless a utility takes on extremely risky ventures, it’s almost guaranteed to be profitable.
They typically pay out a large part of their earnings in dividends. Because all their expenses are factored into the formula for determining the utility’s profit, utilities have little need to reinvest profits into the business. With a lot of cash and limited potential for seeing the stock’s price rise by a large amount, utilities pay out 60 to 80 percent of their annual earnings to shareholders. The typical return on shareholder equity is between 10 and 12 percent.
They enjoy such steady and predictable cash flows that they rarely cut dividends. In fact, profits and cash flow are large enough to allow the companies to hike their dividends on a regular basis. When evaluating their dividend growth, look for consistent increases that keep pace with the rate of inflation.
