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Ideas for Income Investors. High Dividend Stocks, Mutual Funds etc.
High Dividend Utility Stocks – Are they a trap for income investors?
Posted by: Dividend Growth Investor (IP Logged)
Date: July 8, 2013 05:08PM
Utility stocks have traditionally been seen as safe investments by retirees looking for high current income. The sector is well known for its rich dividend policies, as most companies in the group tend to distribute an above average portion of earnings out to shareholders in the form of dividends. As a result, most utility stocks end up paying above average yields to investors. It is not surprising then that many retired investors have preferred utility stocks for their high yields.
I own shares of two utility companies at the moment in my personal portfolio - Dominion Resources (D) and Con Edison (ED).
Dominion Resources, Inc. (D), together with its subsidiaries, engages in producing and transporting energy in the United States. This dividend achiever has raised distributions for 10 consecutive years. Over the past decade, distributions have been raised by 5%/year. The stock is trading at 16.80 times forward earnings and yields 4%.
Consolidated Edison, Inc. (ED), through its subsidiaries, engages in regulated electric, gas, and steam delivery businesses. This dividend champion has raised distributions for 39 consecutive years. Over the past decade, distributions have been raised by 0.90%/year. The stock is trading at 15.10 times forward earnings and yields 4.20%. In 2012 I sold most of my stock in Con Edison and replaced it with ONEOK Partners (OKS). This remaining position in the stock accounts for 0.07% of my total portfolio size, because it is sitting in a legacy account, where the transactions costs and paperwork involved are prohibitively high in relation to the position size. As a result, I am better off simply sitting on it. Dominion accounts for 1.56% of total portfolio size.
The business model of a typical utility is pretty stable. Most publicly traded utilities are involved in the generation and/or transmission of electricity, natural gas or water. Utility companies are heavily regulated and have the monopoly to conduct their business over a certain geographic area. Governments have decided that competition for a service such as electricity would be too costly over a certain geographic area, and have thus granted the monopoly to the utility company. The corporation has to abide by the government regulations however, which limit how much prices can be increased and what target return on equity should be achieved. This creates a very stable business environment, which is characterized by consistent cash flows, and stable dividend payments. You would not see a utility company delivering double digit earnings increases over time, but you would also not see many utility companies going broke either.
Despite this stability, few utility companies have managed to have a long and meaningful records of dividend growth. I analyzed the dividend records of the companies comprising the Dow Jones Utilities average index, and noticed that most utility dividends do not tend to increase over time. It is evident that utility dividends tend to increase for a period of one or two decades, before the rise is interrupted followed by a steep cut in distributions. After the dividend cut, distributions start increasing once again, before reaching a high point, after which dividend growth stops or turns into dividend cuts again. This cyclical nature of utility dividends exposes investors to the ravages of inflation, since purchasing power of these distributions is eroding over time without any meaningful growth.
There are many reasons behind dividend cuts for utilities. Some of them include nuclear disasters, failure to effectively deal with regulators, or failure to effectively pass on cost hikes to consumers.
Incidentally, because of the cyclical nature of dividend cuts and increases, utilities are one of the few sectors where it might make better sense to purchase after a dividend cut. For example, Con Edison suspended dividends in 1974, from the 11.25 cents/share paid every quarter. Later in 1974, the company initiated a quarterly dividend of 5 cents/share, which has been increased ever since. $1 invested in the company after the dividend elimination would have turned into over $350 over the next 39 years.
Most younger Americans do not remember the Three Miles Accident in 1979, which was a partial nuclear meltdown that occurred in one of the two United States Three Mile Island nuclear reactors in Dauphin County, Pennsylvania, on March 28, 1979. It was the worst accident in U.S. commercial nuclear power plant history. The project was operated by General Public Utilities (GPU), which cut dividends in 1979 and then suspended them in 1980. The dividend was not reinstated until 1986, but by 1992, the stock was up almost 9 times in value since the accident, and the dividend exceeded the amounts from before the accident. GPU is now part of FirstEnergy (FE).
That being said, utility companies could be good investments that can generate current income in retirement for retirees. However, always make sure you get the facts, prior to investing in utility companies. This involves reading annual reports, purchasing at attractive valuations and not over committing your portfolio allocation to this or any particular sector. At this moment however, I do not view utility companies as favorable investments as a group, because of their low current yields and low expected growth rates. If I had held utilities purchased at least several years ago at lower prices however, I would probably keep holding to these shares, although dividends would be either spent or allocated elsewhere.
Full Disclosure: Long OKS,ED, D.
Stocks Discussed: OKS, ED, D, EIX, AEP,