For the average retail investor, the hunt for income and stability continues to rage as the markets have resumed their roller coaster ways over the last few months. Safety, in the form of treasuries and cash, continues to pay next to nothing, and the up-down movements of the equities markets is enough to make one sick. To that end, investors have flocked to low volatility portfolios like the PowerShares S&P 500 Low Volatility (ARCA:SPLV), or other exotic strategies to gain yield and stability. However, one simple and classic solution could be just what portfolio's need in this wonky market.
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The Portfolio Power Play
Featuring tax-friendly and growing dividends, recession-resistant earnings and high barriers to entry, the utilities sector could be just what investors are looking for in this market. The sector continues to shed its "widow-and-orphans stock image" and outperform the broad markets. So far in 2011, Morningstar's (Nasdaq:MORN) regulated electric utilities index has returned nearly 4.5%. What's more impressive is during that timeframe the S&P 500 lost 6.9%. These gains have been built on the backs of warmer summers, colder winters and better management. Unlike the 1990's, when many utility companies ventured into unrelated sectors like banking and real estate development, today's utilities are more focused on providing electricity, gas and water. On top of this, grid upgrades and new additions into renewable energy sources are giving the many old stodgy power producers a new growth image.
This new growth coupled with the fact that the lights need to stay on, regardless of any uncertainty, produces some of the highest consistent dividend yields in the market. The broad proxy for the sector, the Utilities Select Sector SPDR (ARCA:XLU) currently pays around 4%. The average utility has a payout ratio of 61%, and analysts estimate that the sector will boost payouts by 7% in 2012.
Yet, despite the high yields, tax efficiency and new growth potential, the broad utility sector still remains one of the cheapest options out there. On average, the group can be had for a P/E of just 13 - well below the 15 to 20 P/E's seen in the 2000's. The group can also be had for cheaper than a variety of other "high yield" sectors like real estate investment trusts (REITs) and pipeline firms. As more baby boomers begin making the transition to retirement and income becomes a prime focus, the utilities sector should see its valuations rise as well. (To know more about P/E ratio, read: Can Investors Trust The P/E Ratio.)
Tapping the Potential
Given the recent sectors continued cheapness and recent market volatility, investors may want to consider the utilities sector for their portfolios. The Vanguard Utilities ETF (ARCA:VPU) makes an ideal, low-cost way to add an entire basket of power, water and electric companies to a portfolio. The fund tracks 85 different firms including heavyweights Southern (NYSE:SO) and American Electric Power (NYSE:AEP). The ETF yields about 3.8%.
Given some of the budget battles a variety of smaller municipalities are facing, privatizing their water authorities to gain access to much needed capital is becoming common place. Water utility Aqua America (NYSE:WTR) has benefited immensely from this trend. The firm added 23 different small water authorities in 2010, and over 200 during the last 10 years. Aqua currently yields 3%. Investors may also be interested in competitors Middlesex Water (Nasdaq:MSEX), which has increased its dividend ever year for the last 39 years. MSEX yields about 4.1%.
Finally, like many other sectors, the utilities are experiencing a wave of merger mania. For investors looking for a little more oomph, betting on the smaller buyout targets could yield better total returns. The PowerShares S&P SmallCap Utilities (Nasdaq:PSCU) allows investors to tap into this potential, while still getting about 3.29% yield. (To know more about buyout, read: Understanding Leveraged Buyouts.)
The Bottom Line
For those looking for income and stability in this roller coaster market, the utilities sector should be on the top of your list. Featuring high yields, cheap metrics and continued growth, the sector should be a part of every portfolio. The previous picks along with the SPDR S&P International Utilities Sector ETF (ARCA:IPU) make ideal selections.
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.