Don't Overlook Utilities

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May 16, 2012

Utilities are the proverbial red-headed stepchild of stock market sectors. During bull markets, so the thinking goes, utilities tend to underperform more aggressive sectors like technology or industrials. But during a good market rout, utilities take a beating along with the rest.

How unloved are utilities?

As I wrote in a recent article, they were by far the most shunned sector by the large money managers interviewed by Barron’s (see chart). Fully 30% of the “Big Money” managers picked utilities as the worst performer of 2012, and barely 3% thought it would be the best. (On the flip side, more than 30% of the managers chose financials and technology to be the best performing sectors, and technology had not a single manager who voted it worst).

As a contrarian trade alone, utilities would be interesting. After all, the sector has been known to take investors by surprise; during the 2003-2007 bull market, utilities were one of top-performing sectors on a price basis, and this did not include the high and rising dividends enjoyed by investors during the period.

And this brings me to my primary rationale for liking the sector. In a world where 2% is a “good” yield on a ten-year bond, the 3.8% paid by the Utilities Select SPDR (XLU, Financial) is attractive. It’s roughly double the dividend yield paid by the S&P 500. And unlike the interest paid by a bond, the dividends of XLU constituent companies have a history of rising over time.

While portfolio growth is essential to meeting your retirement needs, growth ultimately doesn’t pay the bills; but income does. Yes, you can sell off appreciated shares to meet current expenses, but that doesn’t work particularly well when the market is trading flat or down. Just ask investors who needed to sell their shares during the pits of the 2007-2009 bear market and panic.

The problem for most investors is that their traditional sources of stable income—bonds and CDs—simply do not pay enough in this interest rate environment. This means that finding a respectable current income often means accepting stock market risk.

Frankly, I’m ok with that. An investor who is comfortable holding a 30 year bond to maturity should equally comfortable holding a solid dividend-paying stock. If income is your objective, the bends and twists of the stock market can be safely ignored—so long as you are reasonably sure that the dividend is safe.

Utility stocks have a place in a diversified income portfolio, but they are by no means the only game in town. Select equity REITS are also highly attractive at current yields. One that I recently added to my Dividend Growth Portfolio is Realty Income Corp (O, Financial). It holds a very conservative portfolio of retail properties and yields a healthy 4.5.%.

Oil and gas Master Limited Partnerships, and increasingly their general partners, are also attractive options. Kinder Morgan Inc (KMI, Financial) is one that I recently added to my Dividend Growth Portfolio. It currently yields 3.8%, and I expect the dividend to increase substantially in the years ahead as KMI’s limited partnership, Kinder Morgan Energy Partners (KMR, Financial), continues to grow and prosper.

Disclosures: Sizemore Capital holds O, KMI and KMR in client accounts.

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