Why are utility stocks doing so well?

It was a good year for utility stocks as investors flocked to these dividend-paying stocks.

Utilities stocks are up 5.66% year-to-date according to the Morningstar US Utilities Index, significantly outpacing the broader market, which is down 18.10% over the same period . The best performing stocks among utilities stocks this year include Sempra Energy (RES)up 31.12% over the year, and Consolidated Edison (ED)up 17.43%.

Normally, this may not be a surprise. In times of market turbulence, investors often favor these stable companies as a defensive strategy.

However, this year is different. Inflation is raging and interest rates have surged — two factors that would normally be negative for utility stocks, especially as state-level regulations limit utilities’ ability to pass on energy costs further. high on their consumers. Moreover, utility stocks were already expensive heading into 2022, and valuations have become even more stretched.

So what’s driving the continued rally in utility stocks?

Normally stable utility stocks could enter a new era of growth

Investors typically flock to utility stocks during times of economic uncertainty because of their stable earnings and high dividend yields.

“Utilities are names that won’t disappoint. Companies are very stable and not really subject to the vagaries of the economy,” says Raheel Siddiqui, senior research analyst and managing director at Neuberger Berman. Utilities also have “great earnings quality,” says Siddiqui.

Earnings quality is insensitive to economic growth, public services are,” he says. They have all the right characteristics to succeed in this environment.”

The stability of utility companies may not be the only factor in their ability to attract investors lately. The federal government, through the Inflation Reduction Act, also known as the IRA, as well as state and local governments, have increased their efforts in investing in clean energy. This will create new opportunities for utility companies to grow over the next decade, said Morningstar senior equity analyst Travis Miller.

“The industry’s long-term growth is better than ever before,” says Miller.

This is a reversal from conditions at the start of the year, when U.S. solar and wind growth faced headwinds from inflation and tariffs on solar panel imports from from Asia.

“A lot of that is now gone,” Miller says. “The IRA and state policy have created incentives to expand renewables at all costs…2023 looks to be a pretty robust year of solar and wind growth [now].”

All of this has contributed to investor enthusiasm, which has pushed up valuations and made utilities the most overvalued stock sector in the market, according to Morningstar analysts. As of Sept. 15, it’s trading at an 8% premium to Morningstar’s fair value estimates.

Line graph showing the valuation of the utilities sector over the past 10 years.

Of the 37 U.S.-listed stocks covered by Morningstar analysts, 26 are overvalued, Xcel Energy (XEL) and CMS Energy (CMS) trading at the highest premium to their fair value estimates, around 26%, in the group. Ten stocks are correctly valued and only one is considered undervalued: NiSource (NEITHER)which is trading at a 9% discount.

“I’m not surprised they got expensive, but I wouldn’t be surprised if they got even more expensive,” says Siddiqui. During an economic downturn, it is common for utility stocks to become even more expensive as investors covet their stability. Over the past 30 years, the sector has delivered an annualized total return of 8.97%, almost in line with the 9.80% of the broader market.

Line chart showing the 30-year total returns of the utilities sector relative to the US market.

Miller points out that there are two major differences between the performance of utilities over the past 30 years, even during an economic downturn, and what is happening now: inflation has never been higher and rates n have not grown so rapidly.

Inflation and interest rates could hurt utilities more than other sectors

“Interest rates and inflation have a more fundamental impact on utilities than on other companies,” Miller of Morningstar said. “It’s unusual compared to past history for utilities to be the second best performing sector when you have skyrocketing inflation and rising interest rates.”

On the inflation front, rising prices increase input costs for utility providers. While some companies in other industries may raise prices to help offset inflation, utility providers may not echo this strategy to the same extent as regulators place limits on the amount they can. charge consumers.

“Their business models don’t keep up with inflation,” says Miller They have a fixed amount of potential revenue, but their costs may continue to rise.

On top of that, utility providers are one of the most indebted companies in the country, with the exception of banks, which makes them particularly sensitive to rising interest rates. Higher rates mean higher borrowing costs, another way utility company costs could rise.

“We see these [interest rates and inflation] as long-term risks to the industry,” says Miller. While he anticipates more growth opportunities for utility companies, that growth could be offset depending on how high inflation is and how long the Federal Reserve keeps interest rates high.

“To me, that suggests we’re going to see lower returns in the sector than we’ve seen in the past,” Miller said.