Best High-Yielding Utility Stocks to Earn Dividends

If you listen to the naysayers, you’ll steer clear of utility stocks. As bears point out, low power prices are pinching profits for companies that sell electricity to the grid. Businesses and consumers are using less electricity, spurring utilities to try to jack up fees to make up for lower revenues. Higher interest rates may be on the horizon, potentially raising utilities’ borrowing costs and making the stocks less attractive relative to other income-oriented investments. Nor is the sector cheap. Despite a 6% slump this year, the utilities sector trades at 15.7 times estimated year-ahead earnings, above the 10-year average of 14.4, according to research firm FactSet.

Yet utilities may still be a good bet, for a variety of reasons. The sector yields an average of 3.7%, well above the 2.1% yield of Standard & Poor’s 500-stock index and the 2.0% yield of the 10-year Treasury bond. Investors also cherish utilities for their defensive characteristics. The companies typically hold up well during economic downturns, and the stocks are less volatile than other high-yield investments, such as energy-oriented master limited partnerships and real estate investment trusts.

Higher interest rates may not be so troublesome for utilities, either. Kiplinger forecasts that the Federal Reserve will raise its benchmark fed funds rate from about zero now to 0.75% by the end of 2016. That’s a shallow increase compared with past rising-rate cycles. (By comparison, the Fed hiked the fed funds rate 17 times from June 2004 to June 2006, pushing the rate from 1% to 5.25%). Moreover, if a utility can boost earnings and dividends by 5% to 6% a year, a small rate increase shouldn’t cause much financial strain, says Ronald Sorenson, manager of the Reaves Utilities & Energy Infrastructure Fund (symbol RSRFX).

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The sector produced positive total returns during the last three periods of Fed rate hikes, says David Burks, a utilities analyst with investment bank Hilliard Lyons in Louisville, Ky. Moreover, electric utilities outperformed the S&P 500 in two out of three of those periods, including a 46% total return during the 2004-06 rising-rate cycle, compared with 15.5% for the S&P 500. “There’s a perception that higher rates are the death knell of utilities,” says Burks. “Historically, that’s not been the case.”

One of Burks’s top picks for income is PPL (PPL, $34.28, current yield 4.4%). Based in Allentown, Pa., PPL delivers electricity to customers in Pennsylvania, Kentucky, Tennessee and Virginia; it also operates four of the 15 distribution networks in the United Kingdom. PPL plans to spend $18 billion over the next five years on new plants, equipment and technology. That’s a steep outlay, but regulators are expected to let the company hike electricity rates to earn a profit on its investment, boosting earnings along the way. PPL is also trying to win approval to charge higher monthly fees for its customers in Pennsylvania. Burks estimates that profits per share will climb at a 4% to 6% annual pace over the next few years, supporting modest dividend growth. PPL shares trade at 16 times estimated year-ahead earnings, in line with the sector’s average price-earnings ratio. (Share prices and related figures are as of October 20.)

Also attractive for income is Duke Energy (DUK, $73.70, 4.5%). The nation’s largest electric power company, with nearly $24 billion in revenues last year, Duke sells electricity to 7.3 million customers in the Southeast and Midwest. The Charlotte, N.C.-based utility also runs a power generation business and has operations in Latin America. Earnings growth has slumped lately, partly because of weakness in the Latin American business. Yet Duke still expects to earn $4.55 to $4.75 per share this year, potentially up a bit from the $4.55 per share that the company made in 2014. Analysts expect Duke to boost profits by 5% next year, and the company recently hiked its quarterly dividend by 3.8%, to an annual rate of $3.30 per share.

NextEra Energy (NEE, $103.94, 3.0%) doesn’t yield as much as Duke or PPL, but it has more potential for dividend growth and higher total returns. Through its regulated utility, Florida Power & Light, the company provides electricity to 4.8 million customers in the Sunshine State. It also runs a large renewable-energy business, selling wind and solar power to utilities in other regions as well. Though power prices are relatively low, NextEra seems to be weathering the downturn; it recently raised its profit forecasts for 2016 and expects earnings to climb at a 6% to 8% annual rate through 2018, up from its previous forecast of 5% to 7% growth. It also plans to hike its dividend by 12% to 14% annually over the next three years. Says Sorenson: “It’s a solid dividend and earnings growth story.”

ITC Holdings (ITC, $33.75, 2.2%) yields less than most utilities and, at a bit more than 16 times estimated year-ahead profits, is a bit more expensive. But it’s one of the most profitable utilities, with greater prospects for dividend hikes and share-price gains than most of its rivals. Based in Novi, Mich., ITC is the largest independent transmission company in the U.S., managing the grid in the South, Midwest and other regions. With more renewable energy being generated in the Great Plains and its other service areas, ITC should profit from higher volumes of power running through its lines.

ITC is also more profitable than most state-regulated utilities, thanks to a favorable government boss: the Federal Energy Regulatory Commission. The FERC allows transmission companies such as ITC to earn higher returns on equity (a measure of profitability) to encourage upgrades and improve the reliability of the grid. The FERC recently trimmed allowed returns for transmission companies in New England, and the agency is now reviewing some of ITC’s rates, which it could cut. Despite that risk, ITC expects operating profits (earnings excluding non-operating expenses, such as interest and taxes) to climb 11% to 13% a year through 2018, and it plans to hike its dividend by 10% to 15% per year over that period—some of the healthiest growth in the utility business.

If you don’t want to pick individual stocks, you’ll find Vanguard Utilities ETF (VPU, $97.03, 3.7%) a good way to tap into the sector. The exchange-traded fund holds 81 utility stocks, including big players such as Duke Energy, NextEra and Dominion Resources (D, $73.69). Its annual expense ratio of 0.12% is the lowest among ETFs that focus on utilities, making it a top choice for cost-conscious investors.