The best utility stocks can provide growth and income in a diversified portfolio. Here are some tips on picking the best ones

Utility stocks include companies that provide electric power, telecommunications and pipeline services. At TSI Network, we continue to recommend that income-seeking investors buy high-quality utility stocks instead of bonds. Their yields are competitive with bonds—and Canadian dividends are tax-advantaged over interest.

While most utility stocks are steady income producers, the best utility stocks also offer opportunities for growth.

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Some of the best income stocks are in the Utilities and Financial sectors

While we continue to recommend that you spread your investments out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities), the proportion of your holdings you devote to each sector depends on your temperament and financial goals.

For example, if you’re primarily an income investor, you may wish to place more emphasis on Utilities and Canadian banks. That’s because these stocks generally pay high, secure dividends, and have long histories of raising their payments, even during downturns. However, at the same time, you’ll still want to make sure your portfolio is well-diversified across all of the sectors.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion. You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Characteristics of the best utility stocks

Traditionally, the Utilities sector is said to suffer when interest rates rise—or if the market is worried about a rise.

Utilities typically have a lot of debt as part of their capital structure, and higher rates make it more expensive to raise money and refinance existing debt. As well, their shares, which typically offer high yields, compete with fixed-income instruments for investor interest.

However, higher interest rates are usually accompanied by increased economic activity and growth. That stronger economic activity is good for utilities: It pushes up demand for their power and so on and at the same time boosts the electricity rates they charge their customers.

Regardless of those positives, as interest rates rise, investors often sell off, or avoid, utilities stocks, and that can push down their price. Given the formula for dividend yield—specifically, annual dividend rate/stock price—a falling stock price (the bottom number in the fraction) pushes up the yield. In other words, when the stock price goes down, its dividend yield goes up.

How to find top income stocks, including the best utility stocks

a) Financial factors:

Start your search by looking for companies that have a 5- to 10-year history of profits. Companies that make money regularly are safer than chronic or even occasional money losers. You’ll also want to look mostly for companies that have been paying dividends for at least 5 years—10 years is even better. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds. The last financial measure we like to see in a company is manageable debt. When bad times hit, debt-heavy companies often go broke first.

b) Safety factors:

We feel that the best income stocks are the ones that are free from business cycles. Demand periodically dries up in “cyclical” businesses, such as resources and manufacturing. You can hold some of these stocks in your portfolio, but keep them to a reasonable part of a well-balanced portfolio.

We are also particularly keen on companies who have ownership of strong brand names and an impeccable reputation. Customers keep coming back to these businesses, and will in turn try their new products.

It may be hard to find companies that have all of these factors, but we feel the best income stocks have many of them.

c) More safety factors:

Picking the best income stocks means picking stocks that have a higher degree of safety built into them. At TSI Network we look for companies that have industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Smaller firms, on the other hand, don’t have that power.

The next safety factor we look at is geographical diversification. We like strong companies that operate Canada-wide, but we think multinational corporations are better. There’s extra risk in firms confined to one small geographical area. The last safety factor we consider is that the best income stocks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies. 

How worried are you about your utility stocks in this environment of increasing interest rates?