A Dominion Energy solar-power facility in Selmer, Tenn.
Daniel Acker/Bloomberg
Higher bond yields are roiling the stock market. Utility shares have benefited—and it doesn’t look like their run-up is over.
The 10-year Treasury yield has surged to 2.83% from 1.51% at the end of 2021, as the Federal Reserve raises borrowing costs to curb inflation. It’s already begun hiking interest rates and is expected to reduce its bond holdings soon—which bodes badly for riskier sectors like industrials, consumer discretionary, and banking, but helps bolster defensive sectors like utilities.
The Fed’s moves have helped send the S&P 500 down 7.8% this year. The Utilities Select Sector SPDR exchange-traded fund (ticker: XLU), meanwhile, is up 6.3%.
Normally, higher yields hurt utility stocks, as they typically accompany strengthening economic demand, prompting investors to favor cyclicals. Utilities don’t see higher earnings growth when the economy strengthens.
Right now, however, higher yields are a result of the Fed trying to slow economic growth, and that’s scaring investors into utilities. Such a slowdown would dent profit gains in cyclical sectors. But utilities’ earnings growth should be stable, as they can keep raising prices for residential and commercial customers, which is precisely why strategists at Morgan Stanley recently upgraded the sector.
Analysts expect utilities’ 2023 earnings per share to rise almost as fast as the S&P 500’s 10% rate, which could decline should the economy falter. Utilities’ steady growth—higher than the low single digits in percentage terms in the past few years—is aided by demand for renewable energy.
State regulators only allow utilities to realize a set return on their assets—roughly 10%. When they invest in renewable projects, they boost their total assets. As their assets increase, their earnings grow almost as fast.
“There’s a lot of macro uncertainty, and this group has a lot of appealing characteristics,” says Wells Fargo analyst Neil Kalton. “If there are some pullbacks, we want to step in and add to positions.”
Consider Dominion Energy (D). The company said in its most recent earnings release that it aims to expand its asset base by 9% annually starting this year. That will drive almost 7% EPS growth, to $4.38, for 2023, according to FactSet. Driving Dominion’s asset expansion would be 11% growth in zero-carbon electricity generation, amounting to about $5.4 billion of a total $7.4 billion in annual investments.
Dominion is “levered to decarbonization and renewables,” says Guggenheim analyst Shahriar Pourreza, who rates the stock a Buy. “They’re going to grow [earnings] into perpetuity at 6% to 8%.”
That could take Dominion stock higher, as it isn’t necessarily as expensive as it looks. At $87.40, it trades at 21.2 times forward EPS, above the S&P 500’s 18.9 times. It’s normal for utilities to trade expensively during heightened economic uncertainty. ”If investors are worried about recession, Dominion is going to work for investors,” says Mizuho analyst Anthony Crowdell.
Write to Jacob Sonenshine at [email protected]
