The Beaten-Down Utility Sector Will Bounce Back in 2016

It's been a rough ride for utility stocks but don't give up on them yet. Here's why this beleaguered sector struggled this year and why it's poised for a comeback.
By Siddhi Bajaj ,

Investors love utility stocks because of a long history of consistent returns and steady cash flows amid volatility in the broader equity market.

And yet, utilities have surprisingly under-performed this year, with the Utilities Select Sector SPDR ETF (XLU) - Get Report down 7.31% year to date, compared to a gain of more than 2% for the S&P 500.

Let's unveil the story behind utilities' fall from grace so far in 2015 and explain why utilities are poised to make a comeback in 2016.

The major cause for the plummet lies in the faltering dominance and slower demand (in regulated monopolies) for erstwhile industry leaders. With renewable energy resources a rising trend across the country, traditional energy providers are now gradually losing confidence and unsure of their hold over consumer demand.

Also weighing on the utilities sector is imminent monetary tightening by the Federal Reserve, which would be a double whammy for the rate-sensitive utilities sector.

Firstly, a rise in short-term interest rates would mean that utility companies such as Dominion Resources (D) - Get Report , Duke Energy (DUK) - Get Report , and Southern Co. (SO) - Get Report , which rely heavily on debt, would have to pay higher interest rates on loans received to fund infrastructure projects and development needs. And with total cash flow numbers in the red for the better part of the part of the year, analysts are doubting whether the sector can manage interest and principal payments.

Secondly, with the interest rate buzz all over the place, investors may consider bond markets to be a better bet with rising yields, especially with falling share prices offering no hope for capital returns. As bond prices and yields move in opposite directions, investors may gravitate towards buying a bond with a higher returns.

And whether mid- or large-cap, companies have independently struggled with internal problems.

For NRG Energy (NRG) - Get Report , investors couldn't stomach the fact that the returns from the company's renewable energy projects failed to offset lower returns from the fossil fuels business.

Mounting operating costs and expenses were sure to exacerbate the situation. To tackle the profitability issue and respond to investors, the company announced its split into a fossil fuel and green company (circa September) and the stock plunged 25% in a month.

NRG

data by

YCharts

For PG&E Corp. (PCG) - Get Report , the case is roughly similar. The company is plagued by higher operational and maintenance expenses as well as regulatory woes.

PCG data by YCharts

But not all is lost. While the sector has taken a beating for most of the year, the trend may just see a reversal.

With the onset of winter, the industry expects the demand for traditional electricity to retreat and solar power to take a back seat. Also, utilities was the second most bought sector in the ETF market for the third quarter of 2015. That means investors are expecting a revival.

And finally, according to Capital IQ consensus estimates, the S&P 500 Utilities index will likely report an earnings growth of 1.7%, higher than that of the S&P 500.

So, if you own utility stocks, the verdict is to hang on. If Warren Buffett's record of buying energy and utility stocks in the past decade is anything to go by, you should consider making place in your portfolio for these income stalwarts.

In fact, Buffett gets sentimental about a specific investing strategy. How come? Because it helped him make his first million back in the day. Click here to learn more.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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