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Weather has been a benefit to the group, as we’ve seen a hot summer and drought conditions increase electricity usage. Interest rates have remained very low, which is supportive for valuations. These are all constructive for the group. 

If I look out longer term, I think that interest rates are certainly something that is going to drive the valuation and thus the performance of the group. To the extent that economic growth continues to remain anemic and potentially low in the United States and globally, that’s going to be a positive for utilities. 

I think that utilities’ value proposition of 5-6% earnings growth plus a 4% dividend yield in the face of a sluggish economic outlook and anemic global growth is going to be a very compelling total value proposition.

Spratt: The answer is all of the above, but in different ways and magnitudes. Electric utility companies have fairly inelastic demand vs. other sectors of the economy so this is low on the list, but regulated infrastructure capital spending programs will drive earnings power going forward. 

These visible growth drivers for many utilities, in a world that lacks visibility, is a noteworthy distinction for the utility sector and adds support to relative valuations. Most of Corporate America has benefited from quantitative easing, but the capital intensive and heavy balance sheet users, like utilities and energy infrastructure companies, have clearly benefited from both the low cost of debt capital from maturing debt refinancing and the added stability by extending the maturity schedules with longer dated bonds. 

Attractive utility dividend yields vs. Treasuries and corporate bond yields in an income-starved world also add support for relative valuations for the group. Regulation requires close attention when investing in this space, and in general, the companies we own have had constructive regulatory support. 

We also see, based on recently completed mergers, greater consolidation support by the regulators. Tougher environmental regulation should continue, but the Environmental Protection Agency lost some teeth as the federal appeals court vacated the Cross-State Air Pollution Rule recently. And finally, Mother Nature provided a consumer-friendly stimulus from the mild weather last winter and reduced heating bills, but this also created some lost revenues for many utilities.

Which electric utility sectors do you believe have the most favorable outlook in the intermediate  and long term, and why?

Kohli: We continue to favor those electricity utilities that are predominantly regulated over electric power generators that rely upon favorable commodity pricing. According to industry estimates, the regulated electrics promise 4-5% annualized earnings growth over the next several years, as continued infrastructure investment is needed to keep pace with reliability and environmental needs in the U.S. Combined with an industry dividend yield of around 4%, regulated electrics utilities should offer high single-digit returns as long as valuations remain in check.

Pursche: We continue to favor high-quality electric utility stocks that have a strong balance sheet and sufficient net positive cash flow to maintain a robust dividend payout ratio.

Shaughnessy: In general, we continue to believe that the integrated electric power companies and select IPPs are better positioned vs. regulated companies going forward. This is based on better growth prospects and lower valuations.

Simmons: I tend to favor either regulated utilities that are trading at a discount to the group or utility companies that are growing their dividends at an above-average rate. I also favor the merchant power companies. 

In general, I tend to favor the more discounted names, because I tend to see value in names in the regulated space — often since there is some level of uncertainty around them. When that uncertainty goes away, they offer better returns as these stocks see their multiples expand. 

Thus, I’ve focused on where I think there’s really value in the space and on the regulated utilities that reside in states where there’s been some uncertainty, such as California, Ohio and Florida. The regulatory construct is actually remaining very constructive for these utilities, but investors have been skeptical. 

I think the most money in regulated utilities is made by investing right before the inflection point in regulation, meaning that when regulation goes from poor or questionable to supportive or good, therein lies the most opportunity to really profit within the sector. I also prefer the merchant power names, because in my experience opportunities really exist when there’s a disconnect between the underlying commodity price performance and the stock price performance. 

In the case of the merchant names, they have materially underperformed the utility sector, and I think that fundamentals on the margin are actually slightly improving now after a tremendous sell offs in the stocks. As a result, I think there tends to be a large-value opportunity among the merchant names.

Spratt: We continue to favor traditional regulated electric transmission and distribution companies with stable earnings power over ones with merchant generation, given the weak power prices. We also concentrate on utilities with often under-appreciated or ignored energy and energy infrastructure operations. NiSource is a good example of the latter. 

We also favor strategically positioned electric utilities with supportive regulators, because we anticipate consolidation to continue. There have been over 90 U.S. utility mergers in the utility space over the last couple decades, and there are still about 100 publicly traded utilities today. 

Consolidation is a very practical way to create deeper pockets to fund capital expenditure programs, mitigate risks and increase the customer base to better manage growth. Size and scale are primary ways to create cost efficiencies, coordinate capital deployment, provide more financial flexibility, diversify assets, spread project risks and leverage existing legacy assets.

What role do U.S. interest rates and their fluctuations play? 

Kohli: A 100-basis point rise in 10-year bond yields has historically had a negative impact over the near term for electric utility stocks, and we think this relationship remains intact. The sector is poised to offset some of its interest rate risk with above-average dividend growth and more frequent rate case activity that adjusts for impacted costs. But the correlation of the asset class to interest rates remains very high. We would expect to see lower regulated asset valuations in the event long-bond yields rose significantly.

Pursche: The current interest rate environment has benefited electric utilities, as well as other sectors and securities with similar dividend-paying characteristics. A significant increase in interest rates among fixed-income instruments such as bonds would likely make dividend-paying stocks less attractive to investors.

Shaughnessy: While our analysts focus on the fundamentals of the businesses they follow, they also try to understand what impact higher interest rates might have on their companies. Electric power companies, and to a greater degree regulated companies, would most likely face a head wind in a rising rate environment. 

Historically, higher bond yields would make utilities slightly less attractive on a relative basis. However, the economic environment must be factored in, as well. Rising rates might be the result of solid economic growth, which would most likely be positive for electric power companies.

Simmons: A slow and moderate rise in interest rates is OK for the group, because the sector will offset higher yields elsewhere with higher earnings and higher dividends. A quick rise in interest rates of 100 basis points or greater would certainly be a headwind for the utility group. 

You could see valuations compress, because a sharp rise in interest rates of over 100 basis points would mean you would have to see higher dividend yields on the stocks and thus lower stock prices to continue to make the utility sector a comparable income vehicle to bonds.

Spratt: Competition exists for income from both debt and equity investments, and lower bond rates make the dividends and dividend growth in the utility sector more attractive in today’s environment. Based on historical yield-spread relationships, electric utilities current dividend yields support higher valuations, and this provides some cushion.  Higher interest rates have a dampening impact on all equities, but we believe a gradual and mild move up in rates of 50-100 basis points seem reasonable and would be manageable for utilities. 

Another consideration for electric utilities is that bond interest rate levels are an input to the return on equity calculation by regulators; so while lower interest rates are generally positive for equities, they also provide some downward pressure on allowed ROEs. Thus, increasing rates can act as a counter-balance and rate of return support for utilities over the long term.