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Quarter-End Insights

Utilities: Back to Fair Value With Some Emerging Opportunities

Utilities investors have buying opportunities but should pick carefully.

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  • On a global basis, utilities now trade mostly in line with our fair value estimates at a 1.0 price/fair value ratio. Most utilities across our coverage universe have aggressive investment plans with mostly constructive public policy support. As long as energy prices remain stable, we expect 5%-7% annual earnings and dividend growth across the sector during the next few years. 
  • For income investors, U.S. utilities' dividend yield premium relative to interest rates has evaporated as interest rates have continued to climb. The spread between utilities' 3.5% dividend yield and 3% 10-year U.S. Treasury yield is the smallest since 2009 and near the 25-year average spread. Utilities had enjoyed a 200-basis-point yield premium as recently as late 2016, which helped cushion the sector from the sharp rise in interest rates. But with little yield premium left, we expect utilities will become more sensitive to interest rate changes.
  • On the active M&A front, Great Plains Energy and Westar Energy closed their merger, creating  Evergy (EVRG). We still expect AltaGas to close its acquisition of  WGL Holdings (WGL) and we wouldn't be surprised if industry consolidation continues.  CenterPoint's (CNP) acquisition bid for Vectren could be a model for future deals.  Dominion Energy (D) and  Scana (SCG) likely will find out by year-end if South Carolina regulators will bless their merger proposal.

Utilities have had a rough road the past six months, down 9% since they peaked in November while the S&P 500 is up 9% since then, both including dividends. No other sector has performed so poorly during that time period. We don't see that trend reversing any time soon. A strong economy and a steady climb in interest rates rightfully could send investors away from utilities.

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Travis Miller does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.