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Shop Carefully for Bargains in Utilities Stocks

The utility sector continues to climb despite rising interest rates. Older income investors, in particular, should take note.

Is it time to power up your portfolio? With their attractive dividends and tendency to hold up well when the stock market slides, utilities stocks have plenty to offer older investors. Yet enthusiasm for the sector has been dampened in recent years by fears of rising interest rates. During the long stretch of low rates, income investors used utilities stocks as bond substitutes—and as rates rise, the thinking goes, they’ll dump those shares in favor of fixed-income holdings.

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But the much-anticipated utility-stock meltdown has failed to materialize. Instead of marching steadily higher, the 10-year Treasury yield climbed from 2.5% to just over 3% earlier this year and then retreated to about 2.9%. Absent a continuous rise in longer-term rates, investors decided utilities stocks aren’t so bad, after all. In the three months ending in early September, the sector climbed 11.7%, versus 3.6% for Standard & Poor’s 500-stock index.

Many utilities sport yields well above 3%, which “still looks quite attractive relative to Treasury yields and corporate interest rates,” says Travis Miller, an analyst at investment-research firm Morningstar. Although there may be short-term pain if rates rise further, Miller says that data from the past 25 years show “no relationship between utilities returns and interest rates for long-term investors.”

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What’s more, “when there’s a lot of noise from a geopolitical standpoint or from economic uncertainty, utilities tend to do better,” thanks to their safe-haven reputation, says John Kohli, manager of the Franklin Utilities Fund.

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Given its recent rebound, however, the sector as a whole is not cheap, and value-minded investors will have to shop carefully for bargains.

Where to Look

Money managers and analysts say they’re finding healthy growth—and attractive income—among utilities that are updating their infrastructure. “The things that will drive utility spending going forward are transitioning from coal generation to renewables and doing grid modernization,” says Phil Sundell, a value fund manager at American Century. Such spending boosts a utility’s “rate base”—the capital invested to serve customers—which in turn helps grow earnings.

Among Miller’s favorites is Dominion Energy (D; recent price, $72; forward dividend yield, 4.6%), which has a strong position in the gas-producing Marcellus and Utica shale regions. Although the company has suffered regulatory setbacks lately, “we think its assets are among the highest quality of all U.S. utilities, and it has some of the best growth prospects because of its location in an energy-rich region,” Miller says.

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Both Miller and Kohli like Duke Energy (DUK, $83, 4.5%). The company has operations in Florida, North Carolina and South Carolina, where it benefits from population growth as well as a favorable regulatory environment, Kohli says. The stock’s high dividend yield, combined with 4% to 6% earnings growth, gives investors potential total returns of close to 10%, he says.

NextEra Energy (NEE, $172, 2.6%), Kohli’s top holding, also has major operations in Florida and is a renewable-energy giant. Its businesses include Florida Power & Light, the state’s largest electric utility, and NextEra Energy Resources, the world’s largest operator of wind and solar projects. Although federal pollution rules are in flux, “states continue to move forward and are thinking longer-term” about renewable energy, Kohli says, and utilities focused on cleaner energy sources will ultimately benefit.

For those who would rather leave the utility stock-picking in the hands of a professional, the Franklin Utilities Fund (FKUTX) is a solid choice—if you can avoid the front-end load. The fund has delivered 10.5% average annual returns over the past 15 years, beating roughly 70% of peers in the utilities category, according to Morningstar.

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