Investing in utilities is a key part of building a balanced portfolio—as well as adding steady, sustainable income

Share prices for many utilities can drop in part to due to market weakness or, as is the case now, high interest rates. In fact, investor worries about rising interest rates have traditionally had a strong impact on utility shares.

Traditionally, the Utilities sector suffers when interest rates rise—or if the market is worried about a rise. Below we share what you need to know for investing in utilities.

Where we set our limits for sector investing, including Utilities

We rarely if ever start out with a holding above 5% of the overall portfolio. If a single stock comes to make up 10% or more of the total value, we consider taking some profits. But it often pays to hold on to a rising stock, even if it comes to dominate the portfolio. This can depend partly on the sector the company is in.

Remember, Manufacturing and Resources are the two riskiest sectors, while Canadian Finance and Utilities are the safest. Consumer is in the middle.

A number of our portfolio management clients hold 10% to 20% or more of their wealth in a single Canadian bank stock, mostly inherited from a parent or grandparent. Often this inheritance came with clear instructions such as, “Spend the dividends, but don’t sell any of the shares unless you’re desperate!”

That advice has paid off. Many have gains of 1,000% to 2,000% or more, not even counting dividends. The outcome would have been less rewarding if the advice came with a bequest of a more volatile Manufacturing or Resources stock—General Motors, say, or Imperial Oil.

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Holding a big part of your wealth in one stock still exposes you to some risk. To offset that risk, you get to defer the capital-gain tax. With bank stocks, you also get a steady stream of sustainable dividends. More to the point, the top banks have a powerful place in Canada’s economy and politics.

If you’re going to overload your portfolio in any sector or industry, the top Canadian banks are a good choice. The Manufacturing and Resources sectors, and even the Consumer sector, are far less dependable.

Investing in utilities: A strong economy is good for these stocks

Utilities have a lot of debt, 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—it’s what we have seen in Canada and the U.S. 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 pushes 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.

We’ve said many times that a high dividend yield can signal danger rather than a bargain. That’s because when a high-yield stock cuts its dividend, its share price generally drops even further. This may be a temporary setback, but it could also be the first concrete sign of the potential risk that the high yield hinted at.

Bonus tip: How to lower the risk of a growth investing strategy

The tips below for lowering your growth investing risk have long been part of the advice we give you in our investment services and newsletters:

• Don’t overindulge in aggressive investments.
• Be skeptical of companies that mainly grow through acquisitions.
• Keep an eye on a growth stock’s debt.
• Keep stock market trends in perspective.
• The best growth stocks should have the ability to profit from secular trends.
• Look for growth stocks that have ownership of strong brand names and an impeccable reputation.
• Balance your cyclical risk.

When it comes to building a growth investment strategy, don’t let sound bites and predictions warp your stock trading decisions. Instead, minimize your portfolio risk by following our three-part strategy: Invest mainly in well-established, dividend-paying companies; spread your money across most, if not all, of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities); and avoid stocks in the broker/media limelight.

Conservative or income-seeking investors may want to emphasize utilities and banks for their high and generally secure dividends. More aggressive investors might want to increase their portfolio weightings in resources or manufacturing stocks.

What would you say are the ideal economic conditions for investing in utilities?

This article was originally published in February 2021 and is regularly updated.