The utility sector is not one that gets a lot of media attention. Most of the more popular stories these days involve financials, technology, energy, or biotech names.  Yet, while the utility industry is certainly mundane, the profit opportunities in the sector are just as good as anywhere else. In fact, right now, they might even better. Here are five reasons why.  

Inelasticity

Utility companies generate steady cash flows regardless of economic conditions. As economists like to say, the demand for utilities is “inelastic”. For example, utilities provide the power that keeps your lights on and the natural gas that keeps you warm in the winter—services that stay in demand even if the economy teeters into recession.

Since utilities can continue to generate profits during economic slumps, this quality makes them a refuge when investors fear a slowdown or recession. Historically, stocks in the sector have earned a “flight to quality” status that helps to keep share prices steady, even when worries about future earnings weigh on other areas of the market like retailers, computer makers, autos, or other companies with profits closely-tied to the economy.

Dividends

Utility stocks have a long history of paying relatively high and steady dividends. A dividend is simply part of a company’s earnings that is paid out to shareholders. Recently, some major financial services companies have announced plans to cut their dividends. For example, due to recent problems in the credit markets, Washington Mutual (WM) said Tuesday that it was cutting its dividend by 73%. Utilities, on the other hand, are not at risk of dividend cuts due to problems in the credit markets.

Table 1 shows ten of the largest utility companies by market value. Although low relative to the past, in the face of faltering dividends in the financial sector and historically low rates on money markets or other interest bearing accounts, an average 3% yield is nothing to sneeze at.

Consolidation

The utility industry has been consolidating through mergers and takeovers. Texas Utilities, for example, was bought out in February in one of the largest private equity buyouts in history. The trend is expected to continue with Entergy, NRG (NRG), FPL, PPL and a number of others all considered possible merger or acquisition candidates. In general, consolidation is a good thing for an industry. It reduces the number of players, makes them more efficient through cost savings, and is a sign that large investors or enterprises are finding value in specific companies within the sector.

Rotation

A final reason to look at the utilities is because money is already moving into the sector and pushing prices higher. The chart below shows the Select Sector Utilities (XLU) along with the Select Sector Financials (XLF). The XLU holds all of the utility companies from within the S&P 500. It has been heading to new highs and is up 13.2% since mid August. However, the XLF, which holds all of the financials from the S&P 500, is down roughly 10% since that time. Money has been rotating out of the financials and into utilities. That trend can continue and help keep a floor under utilities should the volatility in the financials continue in 2008.  

 
Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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