Electric utilities have continued to provide investors with reliable income in an era of low market yields. We asked five experienced electric utility portfolio managers for their thoughts and outlook on the sector: John Kohli, CFA, portfolio manager of the Franklin Utilities Fund (FKUTX); Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund (MPDAX); Maura Shaughnessy, CFA, portfolio manager of the MFS Utilities Fund (MMUFX); Douglas Simmons, portfolio manager of the Fidelity Telecom and Utilities Fund (FIUIX) and Bryan J. Spratt, CFA, portfolio manager and research analyst with Miller/Howard Investments.

Which sectors of the electric utility universe do you focus on?

John Kohli, Franklin: We follow all sectors of the electric utility universe, including the more market-based integrated companies and independent power producers (IPPs). We maintain a specific focus on regulated companies.

Oliver Pursche, Goldberg Financial Services: Municipal and regional public electric utilities.

Maura Shaughnessy, MFS: Within electric utilities, we typically own mostly integrated and, to a smaller extent, independent and fully regulated companies.

Douglas Simmons, Fidelity: I focus on all aspects of the utility universe—electric, gas and water, in addition to looking at pipeline companies.

Bryan Spratt, Miller/Howard: Utilities are a core focus for Miller/Howard, as our firm’s initial investment strategy in the early 1990s was in fact a dedicated utilities portfolio, and nearly all of our portfolios maintain varying degrees of utility exposure.

Our investable universe includes all utilities—water, gas, telecom, electric and Federal Energy Regulatory Commission (or FERC)-regulated pipelines. Companies within our portfolio participate in regulated service, as well as competitive generation and renewable and other non-regulated businesses.

Have the sectors performed as you expected recently?

Kohli: We’ve been comfortable continuing to own regulated utilities. We like the fact that capital spending remains healthy, generating decent growth in the overall rate base.

Utilities have also done a great job communicating with their regulators to insure that this spending is prudent and gets favorable earnings treatment. Although regulated utilities have underperformed the S&P 500 in 2013, we are satisfied with the positive absolute returns these companies have provided. We recognize the fact that utilities historically underperform during equity bull markets, and that is precisely what has been happening in 2013.

Pursche: While we were pleasantly surprised by the strong performance in 2012 and early 2013, we were equally unpleasantly surprised by the sharp correction in the sector over the past three months. While electric utilities had demonstrated a certain immunity to interest rate risk, the recent sharp rise in yields and concerns over further spikes, along with ongoing revenue and earnings weakness, appears to have caused a significant shift in investor sentiment.

Shaughnessy: The different segments within electric utilities have generally performed as expected. This is typically based off of investors’ risk appetite and yield interest.

When risk appetite is low and investors are searching for yield, regulated higher yielding utilities tend to outperform. The reverse of this environment tends to favor independent and more integrated utilities that are more economically sensitive.

Simmons: Going into the year, I thought you needed to be particularly cautious with your yield exposure. My expectations and what I tried to focus on were the names that were in a position to grow their dividends aggressively.

I think some of the regulated utilities, which are exposed to natural gas infrastructure, have actually done particularly well and have kept up with the market and in some cases exceeded the market. The more commodity-sensitive utilities, which are the deregulated utilities, have really continued to lag. I’ve largely shied away from those names. The commodity-sensitive names, which are the deregulated utilities, have continued to see lower earnings revisions and weaker stock prices in the face of weak commodities.

Which factors have the most influence on electric utility returns?

Kohli: Two factors weigh most heavily on electric utilities. First is the impact of long-term interest rate movements. We’ve seen in the second half of 2013 negative performance of utility stocks due to the steady rise of rates. Utility managements have signaled for higher dividend growth than we’ve seen in the past several years, so this might help offset higher interest rate movements as dividend yields readjust.

The second major factor for performance is regulation. We continue to believe the industry focus over the past several years of strengthening and maintaining their regulatory relationships should help drive more stable share price performance over the intermediate term.

Pursche: It is fairly obvious that interest rate moves will have the greatest short-term impact on electric utilities, followed by the regulatory landscape. Weather patterns are reasonably cyclical and are least likely to have any significant impact. However, economic growth, the health of municipalities and therefore the ability for utilities to pass on cost increases will also play a role in stock performance.

Given the current landscape and the likelihood of a further steepening of the yield curve, our outlook for the sector in the short to intermediate term is somewhat bearish, with an expectation of underperforming other higher yielding sectors (for instance, consumer staple, food and beverage, and large pharmaceuticals). Nonetheless, patient income-oriented investors should not abandon the area as the long-term outlook is still constructive.

Shaughnessy: Over the intermediate to long term, which I’ll define as several to many years in length, electric utilities should be influenced mostly by economic growth and the regulatory environment. Interest rates will most likely have some influence on the space, as utilities and other higher yielding sectors tend to face headwinds during periods of significant and quick moves up in rates.

Simmons: I think the biggest driver in the intermediate term is certainly interest rates, because the group is somewhat of a bond proxy; and as bonds move down with higher rates, utilities tend to move down in sympathy. On the deregulated side, I would say that power and gas prices are going to be one of the longer-term drivers of the group. That’s due to the importance of power prices on regulated power companies’ earnings and stock prices.

Spratt: At the moment, we feel interest rates are having a greater than normal impact on utility returns, in part due to the fact that a three decade-long trend of declining rates appears to be coming to a close. Insofar as regulators fully compensate utilities for higher borrowing costs—and investors for higher related costs of equity—utilities should remain healthy in an environment of gradually rising rates.

In most jurisdictions, the regulatory compact remains strong and capital spending needs are robust. Thus, we see interest rates as having little impact over the medium- and longer-term, as we believe regulators generally take appropriate steps to ensure utilities capital costs—both debt and equity—are covered. We tend to place far greater emphasis on secular economic growth and regulatory developments as key factors in determining longer-term returns for utilities in our portfolio.

Which electric utility sectors do you favor, and why?

Kohli: We continue to favor regulated utilities and the integrated power generators that rely upon improved commodity prices to drive earnings growth. Whereas integrated utilities remain fundamentally challenged, regulated electrics offer earnings and cash flow stability. We believe investors have a growing appreciation for the stability provided by the sector.

Although electricity demand remains stagnant, earnings growth for the regulated electricity sector remains in a 4-5% range over the next several years as continued infrastructure investment is needed to keep pace with reliability and environmental needs. Combined with an industry dividend yield of around 4%, regulated electric utilities offer high single-digit returns provided valuations remain constant.

Pursche: We are generally bearish on the sector in the short to intermediate term. Over the long term, we believe diversified utilities … are best positioned.

Shaughnessy: We favor companies that have attractive valuations, good growth prospects, can generate free cash flow, have shareholder-friendly management teams and good regulatory visibility, where appropriate. In general, we have found more integrated or independent electric utilities than regulated businesses with these characteristics.

Simmons: There are many utility names that are benefiting from the shale gas revolution. Utilities are involved in the building of the pipeline infrastructure to meet increased natural gas demand and also increased natural gas supply.

The utilities that are involved with building out this natural gas infrastructure, meaning the pipelines, the gathering, the processing and potentially liquefied natural gas (or LNG) export of this gas, all these names are seeing superior dividend growth, and I think are the real secular growers within the utility space.

Spratt: We continue to favor regulated electric transmission and distribution companies with supportive regulators, stable earnings power and attractive capital expenditure (or capex) programs to drive earnings power and dividend growth.

We have avoided most of the merchant generators in recent years given the ongoing weak power price environment, but this could change in the coming years as environmental standards from Mercury and Air Toxics Standards (MATS) takes effect in 2015-2016 and more coal-fired plants retire.

We also focus on utilities with often under-appreciated or ignored energy and energy infrastructure operations. As an example, this year we saw two of our utility holdings … combine their midstream assets and form a nearly $11 billion private MLP that is expected to come public in the near future. Both stocks have done well.

We also look for solid utilities that have multiple emerging opportunities to be successful and to outperform the group.

What is your outlook on electric utilities’ total return potential?

Kohli: We think utilities can continue to provide decent returns over the long term. We like the fact that electric utility managements are committed to their core franchises and focused on providing clean, low cost and reliable electricity service to their customers.

In the past, these companies have faced difficulties when they’ve strayed too far away from their core competencies, but this is not the case today. Capital expenditure will be trending down for the industry over the next few years after several years of peak spending, which bodes well for increasing levels of free cash flow.

These management [teams] have exhibited a willingness for passing on this cash flow to shareholders in the form of dividend increases, and we think that is the right direction to be heading. We remain favorable on the regulated electric industry for this reason.

Shaughnessy: Over the intermediate to long term, electric utilities will most likely continue to offer an above-average yield compared to the broad market, and the potential to grow roughly in line with the broad economy.

Simmons: Utilities are a good way to get tax efficient income and a good total return. Remember that dividends are taxed at 20% compared to bonds at ordinary income. So, I think utilities are a very tax-efficient income vehicle and offer a good total return.

I believe the best names within the utility sector are involved in building out the needed natural gas infrastructure for the country and those names focused on building electric transmission. Utilities focused on these two areas can grow earnings 6% or better while also offering a 4% dividend. So, I think you’re looking at a total return of 10-11% for the best utility names, which is really an attractive investment in any rate environment.

The other thing for investors to remember is that utilities are a relatively safe investment, as most of their operations are domestic, and their earnings are largely recurring. Even in a very strong market like you’ve seen year to date, utilities are still offering positive total returns; they just may not be as offensive as the broader market, but the group is likely to hold up much better in the event of a correction.

Spratt: One longer-term factor that we will need to closely monitor is utilities’ and regulators’ responses to evolving demand environments. Indeed, in many regions, capital spending is rising, but end-user demand is not.