If it is true that markets are driven by fear and greed, 2022 has so far been the year of living fearfully.
2022 started out well with the S&P 500 Index an all-time high at 4,796 on January 3. But with the US Labor Department reporting the highest year-over-year inflation since June 1982, an increasingly aggressive Fed and prospective rate hikes to combat inflation, the market began edging down. Russia’s invasion of Ukraine in March, with consequent humanitarian, geopolitical, and economic consequences, not the least of which were higher energy prices, and the economic consequences of China going back into lockdown as COVID cases spiked, also put downward pressure on stock prices.
By the end of the first quarter, the S&P 500 Index was down 5% from the start of the year, with nine of its 11 sectors posting losses, and the only “green” on screens from Energy and Utilities.
Utilities have historically been a defensive investment option in troubled times, which has certainly held true this year. It is important however, for investors to understand both the factors contributing to the sector’s outperformance in the current market environment, as well as the companies with higher growth potential.
Regulated utilities can offer predictable earnings and income
The demand for power is not closely linked to the economic cycle, and as a result, utility companies offer the potential for more predictable earnings growth and dividends even in times of economic trouble. In addition, utility rates are regulated, and during periods of high inflation are typically able to pass on higher costs to consumers. Regulated utilities can also recoup capital expenditures on new infrastructure projects through an increase in their rate base—providing a pathway to growth in revenue and earnings.
We estimate the sector’s earnings should rise 6-7% annually, with a dividend payout of 3%. But not all utilities are the same. We look for companies with a growing service territory, operating in sympathetic regulatory jurisdictions, and with higher potential earnings growth, while trading at reasonable valuations.
CenterPoint Energy (CNP) is our top stock pick in the group. The Texas-based utility is benefitting from the relocation trends in America. The company gets 55% of its revenue from Houston Electric, serving a population that has been growing for the past few years, in contrast to cities such as Los Angeles and New York which has seen outwards migration.
Houston’s population growth is driving demand and creating opportunities for more capital investment, which, in turn, increases the rate base and can lead to higher revenue and earnings growth. CNP recently converted to a fully-regulated utility and applied for its distribution cost recovery factor (DCRF), a special interim rate adjustment allowed in Texas which does what. CNP’s 8% earnings per share compound annual growth rate (EPS CAGR) is among the fastest growers, yet valuation is reasonable, with shares trading at a 3% premium versus its peers.
LNG stocks could benefit from the insecurity in energy markets
The conflict in Ukraine is disrupting global energy markets as countries reevaluate reliance on Russian oil and natural gas. There is renewed emphasis on energy security, and increased urgency for countries to accelerate their transition to cleaner energy.
Certain companies involved in natural gas are poised to benefit from these trends, and from today’s higher prices. One such company worth highlighting is Sempra Energy (SRE), which operates public energy utilities in California and Texas and also builds energy infrastructure, including liquefied natural gas (LNG) exporting facilities. The company is developing LNG facilities on the Pacific coast of Mexico and on the Gulf coast.
While it takes many years for a new LNG export facility to come online, Europe’s reconsideration of its energy security and the current high prices for LNG should make it easier for Sempra to complete new projects. For example, we believe the current dynamics in the market make it more likely that the Port Arthur project – comprised of two natural gas liquefaction trains capable of producing, under optimal conditions, up to approximately 13.5 metric tons per annum in the aggregate – can secure long-term LNG contracts that help the project move forward.
Interest rates not (yet) impacting the sector
While rising interest rates create headwinds for utility stocks, we have not yet seen that dynamic despite the strong move upward in rates. Investors are more focused on the risk of recession and inflation, and utilities are attracting interest from atypical investors looking for a safe haven.
This demand, combined with longer-term trends driving earnings growth for well-positioned utilities companies, should continue providing tailwinds for the sector.