When you’re looking for a safe investment in the stock market, utility stocks often fit the bill, providing reliable dividends and modest capital gains.
Utility stocks have moved little over the past 18 months. The flat returns during that period “constitute the sector’s worst absolute performance since the 2008-09 recession,” Morningstar utilities strategist Travis Miller wrote in a commentary.
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“This is due in large part to a long-overdue valuation correction. Utilities traded above our fair value estimates and the sector’s long-run average valuations for most of the last decade.”
Utilities peaked at 22% overvalued and a price-earnings (PE) ratio of 26 in early 2020, he said. Since then, valuations have come down, while earnings and dividends have risen.
“We now consider the sector fairly valued, with more than half the utilities In our coverage trading below our fair value estimates,” Miller said. “The sector’s trailing PE ratio of 20 remains above the long-term average, but we think that’s justified given its strong financial health, long-term earnings growth potential, and upside to the clean energy transition.”
Utility companies have strong balance sheets, and dividends are well-covered by earnings, he said.
“We expect most companies can grow earnings 5%-7% annually for at least the next five years. That growth could last a decade or longer if the clean energy transition continues,” Miller added.
Such earnings growth and dividend yields topping 3.5% suggest 8%-10% long-term returns for utility stocks. Miller said.
As for the short term, utility companies will suffer from higher interest rates and elevated inflation, he said. But “utilities that can maintain lean operations should outperform during the coming quarters.”
Here are Miller’s top three utility-stock picks.
Entergy
Miller’s moat (durable competitive advantage) rating for Entergy (ETR) -): narrow. Miller’s fair value estimate: $120. Friday’s closing price: $97.46.
“Entergy’s [4.47% forward] dividend yield and our outlook for 7% earnings growth represent one of the best total returns in the sector,” he wrote.
“Entergy shareholders also could benefit if the stock erases its current 15% valuation discount to peers.” Clean energy investments will help fuel the company’s growth, Miller said.
NiSource
Miller’s moat rating for NiSource (NI) -): narrow. Miller’s fair value estimate: $33. Friday’s closing price: $27.52.
“NiSource is a high-quality utility trading at the same valuation as its lower-quality peers,” Miller wrote. “The firm’s transition from fossil fuels to clean energy in the Midwest supports a decade of above-average growth.”
NiSource plans to close its last coal-fired power plant in 2028 and replace the generation with wind, solar, and energy storage, he noted.
Duke Energy
Morningstar’s moat rating for Duke Energy (DUK) -): narrow. Morningstar’s fair value estimate: $105.00. Friday’s closing price: $89.77.
“After divesting its renewable energy business, Duke has a clear pathway to achieving management’s 5%-7% earnings growth target,” Miller wrote.
But the divestment didn’t take Duke out of the clean energy business. Its capital investment plan for 2023-27 focuses on clean energy and infrastructure upgrades to reduce carbon emissions, Miller explained. And Duke has a lofty forward dividend yield of 4.51%.
The author of this story owns shares of Duke.
