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Utility shares – what to look for

We look at what investors need to know when looking at utility shares.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

In times of economic uncertainty, investors have tended to turn to more defensive sectors in search of more stability. Utility shares have tended to fit that bill.

These are private companies that provide necessary services like water, electricity and gas. Most of us pay a monthly utility bill, which makes understanding how their businesses work easier. But understanding the specific risks and opportunities for each different company takes some sussing out.

We’ll break down some of the industry jargon and flag what we look for. This’ll help give you some tools to make more informed investment decisions. Please remember that all investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Types of utilities

There are three main categories of utility shares: water, gas and electric. Some operate in just one segment, and others offer a variety of services. Water and gas utilities are relatively simple to understand. They purchase the water or natural gas, prepare it for usage, and transmit it around the country.

Electricity providers can be a little more complex. They can be responsible for generating electricity, transmitting electricity, or both. Controlling the entire process has its advantages. But it can also attract more regulatory oversight to make sure consumers are getting a fair price.

The reality of regulation

The nature of utilities’ offerings means demand is relatively constant – even if times are tough, most people will find a way to keep the lights on. To make sure these essential services are accessible, the government regulates utilities. The regulator will set limits on what companies can charge its customers and how much it’s required to spend to keep the network working efficiently.

This can be a double-edged sword. Sometimes this means a cap on what utilities can earn with stringent price controls. It can also force utilities to spend more on network upgrades. But it helps shelter them against risks like rising inflation and unforeseen events – most regulators allow utility stocks to raise their prices alongside inflation.

Growth potential

The business of supplying water and power is relatively mature, so growth is hard to come by. That means profits are typically split between maintaining a healthy network and shareholder returns, with an emphasis on shareholder returns.

With that said, where and how a utility operates will determine how much potential growth is on the horizon. For those generating and delivering electricity, the shift toward electric vehicles presents a unique opportunity. Plus, the push toward green and renewable energy adds another layer of potential growth to the equation.

The dividend proposition

Dividends, rather than growth, have tended to be the main attraction for owning a utility share. The fact that they can flex prices alongside rising costs allows lots of the sector’s players to offer dividend growth at least in line with inflation. Add to that the nature of utilities stocks and ability to bring in new money, and you have the makings of potentially relatively secure dividend growth. Remember though, past performance is not a guide to the future and dividends are variable and never guaranteed.

Forecast dividend yield

Source: Refinitiv 02/12/21. Yields are not a reliable indicator of future income.

Utilities can estimate future revenue with a good degree of certainty, which makes it easier to set a dividend policy and stick to it. This isn’t a hard and fast rule though – as we saw last year, no dividend is ever guaranteed. The sudden, unexpected drop in demand for water and electricity at schools and businesses was a shock to the system. Putting many dividends on the chopping block which is a useful reminder.

That’s why it’s important to look at a utility’s underlying business and whether it can reasonably support the yield on offer.

Understanding underlying

Underlying figures are a mainstay for most companies. They usually strip out one-time costs to give investors a better idea of how the business is faring. This is the same for utilities, but they also include an important adjustment based on regulatory rules.

Utilities can collect a certain amount of revenue, in line with the regulator’s rules. If they’ve gone over the limit one year, they’re required to lower prices in the next to make up for it. The reverse is true as well. The underlying revenue and profit figures usually take these over and under-recoveries into account and smooth out the overall revenue figure.

Regulatory Asset Value

Another important figure to watch is the Regulatory Asset Value (RAV). Regulators require utilities to spend on improving their networks, and in exchange allow them to earn a financial return for doing so. RAV is the invested capital that the utility can earn a return on. The larger the RAV, the better the potential for earnings growth.

RAV is essentially a cost that the utility has been permitted to recoup through customer fees. Rather than showing up as an expense, it’s recorded on the balance sheet. When a utility is spending a lot, you’d expect to see significant RAV growth. If not, it’s a sign the money isn’t being efficiently managed.

RAV is also a useful way to evaluate gearing, or how much of the company’s growth is funded through debt. Net debt divided by RAV will give you a regulatory gearing ratio. It’s an important factor in determining creditworthiness. A gearing ratio that’s too high will make it harder for the company to take out low-cost loans. Regulators estimate that a ratio around the 60% mark is the norm.

The debt issue

Utilities have tended to carry a lot of debt. That’s because they pay most of their earnings back to shareholders, so major network upgrades are often debt-financed. This isn’t necessarily a bad thing – particularly with interest rates at historic lows currently, making it relatively cheap to service.

Bank of England interest rate history

Source: Bank of England, 02/12/21 (unchanged since March 2020).

Still, an overwhelming pile of debt puts strain on operations and could see the dividend on the chopping block.

But all debt isn’t created equally, particularly with inflation on the rise. A portion of utilities’ debt is typically inflation -linked. That means when prices rise, so does the interest rate on debt repayment. Over the past few years, inflation linked debt has been cheap to hold. But the recent spike in consumer prices has changed that. If inflation is temporary, this shouldn’t have a long-term impact. But if it persists, those utilities with a high proportion of inflation-linked debt could find it more difficult to pay their dividends.

Sifting through the sector

The utility sector is a good place to go looking for defensive, income stocks. While a high dividend yield might look appealing on paper, it’s important to do your research to make sure it’s sustainable and not just a spike or reaction to the market. In addition to looking at the health of the underlying company, you can do a more general analysis of the dividend using the tools outlined in this article. Remember ratios and measures shouldn’t be looked in isolation either. It’s so important to look at the bigger picture.

We know not everyone wants to do the all legwork themselves. If that’s you, our share research can give you expert insight straight to your inbox to help with your investment decisions.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This is not personal advice. If you’re not sure an investment is right for you, seek advice. Past performance is not a guide to the future.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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