Is Investing in Utilities Profitable?
Investing in utilities is always a debatable matter.
There are some who believe that investing in these can yield best long-term results.
But many others feel there are many reasons for not investing in utilities.
In fact, the utility sector has many dimensions associated with it.
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Some see it as pure dividend plays.
Others don’t want to risk the Government role in this.
For some, the Government’s association is a major reason why they want to invest in it.
As the name indicates, the utilities sector provides some or other form of utility products like electricity, water or gas.
This essentially means that demand for these products will remain a constant.
But then, there is also the prospect of renewable energies replacing traditional utility products.
Well, all that is in the realm of possibilities.
That said, you cannot deny the fact the utilities do come across as an attractive investment zone.
There are many who look at this sector as an attractive defensive play for the long-term.
However, some groups of investors are still confused.
They are unable to assess if investing in utilities will be profitable.
Well, it totally depends on your investment objective.
Different types of investors have different kinds of expectations from the market.
The idea is how best they can apply the market forces to realize their objective.
After all, the utilities firms have some unique challenges too.
Most of them have a heavy debt component also.
This is because they involve large projects with mega investments.
So when you are investing in these, you will have to pay attention to all these factors.
We decided to unlock the intrinsic value in the utilities sector and the associated risk.
This will help you take a conclusive call.
Understanding the Utilities
The first step in analyzing investing in utilities is knowing the sector in detail.
As we mentioned, utilities are primarily infrastructure plays.
They comprise of a variety of useful services that are indispensable for our day to day lives.
They involve the likes of gas, power and water.
More often than not the utilities are integrated plays.
By this, I mean that they do not just cater to one isolated aspect of a sector.
They are by far the most impactful infrastructure plays with massive investment.
As a result, these sectors are also the ones that involve a high degree of debt.
Typically most of these stocks have a high debt-equity ratio as well as well spread out capex plans.
Along with the capital expenditure involved, you will have to account for the cashflow levels here.
While normal business fundamentals can be applied, the readings are distinctly different for utilities.
For example, a high debt-equity ratio is a major red flag for most businesses.
But when you compare the utilities, it is almost the norm in most cases.
Given the extent of capital expenditure that they have, they generally have major debt too.
As a result of these huge debts, they are also susceptible to changes in the interest rate scenario.
So, many factors may impact the overall growth and investment in this sector.
Rising interest rates and declining rates have different types of impacts on these stocks.
If you are investing in utilities, you will have to take a constructive view on rate outlook as well.
The rate of interest also impacts the overall cost of capital.
So it becomes necessary to condition and moderate your investments accordingly.
Government policies also have a major impact on utilities.
Assessing Debt in Utilities
Therefore, the debt level is a key element to track while investing in utilities.
The continuous fund flow is a cardinal necessity for most utilities companies.
Upgrades and maintenance are an inevitable part of their growth structure.
All of these are incredibly capital intensive and need sufficient amount of funding.
The funds generated from revenue earned can fulfill only part of the deal.
Most of these basic amenities provider are heavy dividend payers too.
While some experts may scoff at the idea, for investors this is a key reason why they buy into these stocks.
So it goes without saying that they have to depend heavily on external sources for capex.
The debt, as a result, is an inevitability that you cannot deny.
Now if the loans are borrowed at higher rates, the interest outgo is also higher.
So, this directly affects the fund flows of the company.
The ratio of cash inflow and outflow is crucial.
The moreover higher rate of interest also results in the higher extent of debt.
If the debt-equity ratio is too steep, this will also affect the overall credit ratings of the company.
The extent of leverage also increases to an undue extent.
This is why monitoring the debt levels in utilities is crucial for investing in these.
It also affects the overall cost of operation in a significant manner.
The cost of operation is a crucial factor in determining the profitability too.
Ultimately, this is a stock and a thriving business.
If profits decline, the relative reason for investment decreases.
This can then affect the demand for the stocks.
It can also affect the extent of dividend payout.
If there is severe cash crunch, there won’t be an adequate amount to pay the dividend.
That can again be a matter of concern.
Gauging Consumer Response to Utilities
When you are analyzing utilities, it is also important to assess the relative demand.
As you already understand, utilities have a cash-intensive business.
This means, whatever loans they may apply for, their intrinsic revenue generation has to be sizeable.
Without proper revenues, they cannot get loans for an extended period either.
The problem here is getting brand loyalty is difficult in this case.
That makes projections also difficult.
Most states allow consumers to switch from one provider to another.
Consumers tend to choose utilizes providers who charge the least.
As a result of it, if a utilities provider prices their product too high, they may end up losing market share.
Often high-priced utilities have to bite the dust.
Even if the cost of operation rises, they will have to follow the pre-determined contract terms.
That means they will have to sell their product at a lower rate.
This hurts profitability directly.
Now when you are investing in utilities, you will have to pay attention to these details.
In this context, utilities have benefited significantly from the current low-interest rate regime.
After the 2008 bloodbath, interest rates have been low globally.
This has impacted the utilities favorably.
The cost of loans have been much cheaper and this ensured that dividend payment remained on track.
This means many conservative investors started betting on these utilities stocks more than safe haven like bonds.
The result, they got higher returns and additional savings.
The growth in housing sector also impacts the growth of utilities.
More houses will mean more demand for electricity and water.
That will surely enhance demand for these utilities and investors will start investing.
This will in turn spur profitability and better growth.
That will also create more demand for utilities stock in the market.
Advantages of Investing in Utilities
That brings us to a crucial point of discussion on the issue.
Is investing in utilities profitable?
What are the advantages of investing in utilities?
Somehow, that is the most important factor that decides the merit of any investment.
One thing that comes upfront is, of course, the regular dose of dividends.
Almost 50% of the investors I have asked or discussed have highlighted their bias towards the dividend.
The dividend flow is a big incentive for most market investors.
This is, at any point of time, a scope for double payment.
But apart from the hefty dividend in question, there are some other distinct advantages too.
Utilities are also considered crucial defensive bets too.
They help provide slow and steady returns over an extended period.
So for many, they are the crucial stabilizing factors in their portfolio.
They invest in these stocks and just keep enjoying the perks year after year.
Most times, the price appreciation in these stocks is a lengthy affair.
It does not happen overnight.
Most times, the process is gradual, and the increase is incremental.
So when you buy utilities, do not expect striking returns in 2 months.
But over 5-6 years, you can expect sterling growth that adds to your bottom line considerably.
They are therefore also the income generating investments in your portfolio.
They do not just promise growth but steady income source too.
Their stability also makes them safe bets in times of economic turmoil.
They represent fundamental growth.
So even if there is a slowdown, people will continue needing utilities.
As a result, the demand cycle remains robust.
This factor also makes them popular safe haven bets.
Investors turn to these stocks when the market situation may be slippery or tricky.
The dividends compensate for the lower stock price.
Problems with Utilities Investment
That brings us to the other end of the spectrum.
What are the downsides of investing in utilities?
This is also a very relevant consideration.
Remember, it is never a good idea to invest in any stock without assessing the risk.
Government policies and regulations are by far one of the biggest risks involved.
A sudden change in regulations may result in the massive recalibration of details.
Or the introduction of new norms will involve a large amount of fresh investment.
For example, the government may pass a new green regulation.
So projects that are established before it will have to recalibrate their business model now.
They will have to make fresh provisions for these new rules.
Economic growth and changing interest rate situation is the other key risk.
It dictates everything from commissioning of new projects to the availability of loans.
Even the cost of loans, operational expenses and all other related expenses are the function of economic situation.
Higher cost or loans can erode growth momentum to a large extent.
In many ways, it puts a brake on the overall growth perspective.
Pricing is another key risk for utilities.
So when you are investing in this sector, you need to be mindful of the prices.
Whether you like it or not, the dividend is the single most important reason why investors put their money in utilities.
Historical reports indicate that there are many utilities world over that have reduced their dividend.
The rising interest and the work with regards to renewable energy is another key risk.
Estimates peg that renewable energy may address demand for as much as 80% of the market by 2050.
Therefore that may be a risk for conventional sources.
That means the growth project for current conventional opportunities may be fairly muted.
This may also eat into their business going forward.
Top Strategies for Investing in Utilities
If you want to understand if investing in utilities is profitable, the strategies that you are employing are important.
The strategies that you may use often dictate the kind of profit that you may earn.
So the question is what types of strategies should you go for?
Let us first get one aspect very clear.
Investing in utilities is primarily about betting on the defensive sector.
By defensives, I am referring to the relative calm and peace that reigns here.
Unlike many other stocks, this sector is never too volatile.
If economic conditions are good, people will splurge on comfort and luxury items.
They will buy appliances like a brand new AC, heating system and the like.
This will result in great utilization of utilities.
But let us say that economy may take a turn for the worse.
The economy starts deteriorating but you are still going to need heat and electricity.
So, their revenues will remain more or less similar.
That way, the economic upheavals do not have a huge impact on the price outlook.
The revenue and the earning both remain stable to a large extent.
This stability often helps these utilities to clock in sharp returns.
Whether you are trading in bullish conditions or bearish markets, the utilities are a good bet.
One of the best strategies is to bet on the longer term.
You can look at putting money here when rest of the market is struggling.
Moreover, the dividends add to the overall income from the stock.
So that, by all means,it becomes one of the most pointed and focused strategies.
It helps you preserve capital, limit losses and weather volatility all at once.
Despite that, you can be confident about maintaining the core profit margin.
The Growth Rate in the Utilities Sector
Now we must also assess the relative growth rate in the utilities sector.
That will help you to decide whether you can churn out profits and how much you must invest in these.
The EPS and the revenue rate are the key factors to watch out for.
As these are largely controlled by the government, the regulations play a crucial role in their growth.
Utilities cannot raise the price of their products on their own.
They need the Government’s nod on it first.
So investors typically assess the growth in utilities on the basis of the historical EPS growth and future projections.
The annual growth over the past 5 years has been hovering around the 13% number.
The average earnings per share in the same period is closer to 4%.
While you are assessing growth in utilities you have to also consider their monopoly status.
These utilities incur a large amount of cash expenses upfront.
But the relatively stable price movement and scope for margins come to its rescue.
That enables the companies to offset the higher initial prices.
That said you must also track the 10-year and 20-year growth outlook
This will give you a realistic picture of the basic growth outlook.
Therefore, if you are interested in analyzing if investing in utilities is profitable, you have to set your objectives.
What is the kind of stock you are investing in and how much returns you are expecting?
The time duration of your investment is very important.
There are many types of utilities you can choose from.
Remember to choose the option that best suits your requirements.
Last but not the least, the dividend outlook utilities is also very important.
All in all, you must choose options that best satisfy all these points in a comprehensive manner.
That will help you realize profits when you are investing in utilities.