If utility stocks had a motto, it might be "Boring is better."
Traditionally, investors have seen utility stocks as reliable, even conservative investments because they deliver high dividends and have a relatively stable business model. With bonds yields still near historic lows, investors hungry for income have been piling into utility stocks, sending their prices higher. Now some are asking if the sector has become too expensive.
We talk about utility stocks with John Kohli, who manages the Franklin Utilities Fund at Franklin Templeton Investments. Answers have been edited for length and clarity.
Q. Utility stocks have typically been seen as such a solid investment. What has changed?
A. I think in terms of the business, not a lot has changed. We consider them still stable investments. There's a lot of infrastructure need and work that is taking place in the utility arena. That is good for utilities because they are the ones implementing conversion from coal to natural gas or building infrastructure to get renewable energies onto the grid.
Utility earnings have over the past decade had about a 4 to 5 percent growth on a yearly basis and we think that will continue for the next decade.
What has changed is the way we look at utilities and how they should perform on a year-to-year basis. Utilities year-to-date are up 24 percent and have done a whole heck of a lot better than they should have. And why is that? It's because they are correlated to the bond market. The decline in bond yields has allowed the bond-like characteristics of utilities to rally throughout 2016.
We make the argument they look expensive to the equity market but they are more correlated to the bond market. If you compare them to what has happened on the federal side and corporate bond side, they still look fairly valued.
Q. So you see them as fairly valued?
A. When you run regression models against the bond and equity market, there's been zero correlation between utility market and say, the S&P 500. But there's extremely high correlation with the bond market. Is that the appropriate way to consider them going forward? In some ways, yes.
Utility earnings are unique because of the regulation. States set return based on the cost of capital. So the model has been pretty consistent for the past few years.
We focus a lot of our time here at Franklin analyzing the regulatory environment. We would be concerned if we saw a rise in regulatory risk. We are still confident.
Q. So what's ahead?
A. Utility companies in general have a good long-term future, given the fact that they are in the base infrastructure business. As new technology evolves, utilities will always be the avenue for delivering it.
We don't see a significant risk to the near-term traditional regulatory model.
We are paying out less of the retaining earnings to drive the growth that is taking place. However, the forecast growth rate of dividends for the industry is 5 percent over the next five to six years.
So they are comfortably within a band to deliver but also sitting nicely to continue to grow going forward.
This story has been automatically published from the Associated Press wire which uses US spellings