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Commentary

High-Quality Opportunities Light Up in Utilities Sector

Utilities' sharp drop since January has created buying opportunities among some quality names with long dividend-growth histories, strong balance sheets, and attractive growth prospects.

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For the first time in 18 months, investors can take a serious look at utilities again. The sector's sharp drop since January has created a long-awaited opportunity for income investors. Several high-quality utilities with long histories of growing dividends, strong balance sheets, and attractive prospects now trade well within buying range, based on Morningstar's fair value estimates.

The last time the utilities sector was this cheap was in 2013, when it briefly traded below fair value. Before that, utilities last traded below fair value in mid-2010. It has been a rapid fall for utilities this year since valuations peaked in January. The sector's 12% drop from its late-January peak is its worst stretch since the market crash in 2008.

Investors seeking 8%-10% total returns with long holding periods now have some high-quality options. Stalwarts such as  Southern Company (SO) , Duke Energy (DUK), American Electric Power (AEP), and PPL (PPL) trade well below Morningstar's estimate of their fair values and yield 4% or better. About 20% of Morningstar's utilities-sector coverage currently trades at 4 or 5 stars, meaning that these stocks are undervalued relative to Morningstar's fair value estimates.

Domestic-utility fundamentals remain strong. We're forecasting median 5% dividend growth for the group during the next three years, with some utilities, such as ITC Holdings (ITC), NextEra Energy (NEE), and Dominion Resources (D), well above that. Infrastructure replacement and efforts to maximize the value of low-cost natural gas supplies support this growth. A sharp uptick in interest rates could stall some of that growth as financing becomes harder to secure. But many of these projects have regulatory support and secure financing.

Going into the summer, we're keeping a close eye on eastern U.S. power markets. The long-developing wave of coal-plant shutdowns has accelerated this year as persistently low gas prices and noncarbon emissions regulations have had their effect. Regulators recently approved PJM's capacity-performance scheme to encourage power-generation reliability. NRG Energy (NRG), Calpine (CPN), and Exelon (EXC) all should benefit from market premiums that encourage reliability and emissions-friendly generation, such as gas, nuclear, and renewable energy.

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Andrew Bischof does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.