Utility stocks are usually thought of as defensive, functioning as a hedge by reducing your exposure to risk, since they go down less. Some provide lots of offense as well.
One of the ways that we measure stocks among each other is how they move relative to the overall market. Stocks that move more than the market, like a lot of technology stocks do, are called high beta and those that move considerably less are termed low beta.
This is a concept that can be used to our advantage by seeking out higher beta stocks when the market is moving forward and avoiding them and preferring lower beta stocks when it is reversing course. It’s actually better to not be in any stock with a decidedly negative expectation over a certain time period, and choosing what would appear to be a better bet among two bad bets doesn’t make much sense actually.
It is the performance of the stock itself that matters here, and if the market is going down and your stock is going down in tandem, your stock going down is what matters and needs to be paid attention to. The goals of investing are to seek to maximize return while managing risk, and the two actually go together hand in hand, or at least should if we are managing risk properly or in a way that is even sensible to do so.
Keeping a certain percentage of your holdings in bonds, which have a much lower beta than stocks on average and deliver lower performance over time, as an overall strategy, is far from the optimal approach, although there are times where this strategy can be an excellent one. This reduces our risk exposure to the stock market, but we do not want to be doing this the way that most investors do, which is to apply this strategy mindlessly.
If we insist on using such a mindless approach exclusively though, where we just set things and forget them, there are going to be cases where we want to both limit our return and risk with this sort of hedge. If we will need to withdraw money from our portfolio, in retirement, then we do need to be careful not to expose ourselves to too much risk, where money that we are taking out would have been better placed in other assets that do not have such a potential for loss.
Otherwise, it’s actually better to have all of our money in stocks if we’re going to let these bets ride indefinitely, for the reasons that they tell us to, the long-term positive expectation. Because the general expectation for stocks is positive, when we apply general hedges such as limiting the percentage of our portfolio in the stock market generally, this will just end up limiting our positive expectation and our returns.
If the average net gain from stocks versus bonds is 3% for example, representing the average difference between stock and bond returns, and we put half of our money in bonds, this half will have an expectation of 3% less. If we’re not expecting to cash out for many years, where this advantage will have a chance to play out, there really isn’t a reason to hedge this way.
If we do not have enough time for this, if we are in a bear market and may not have enough time to recoup any further losses that we may incur, we actually should not be in stocks at all, and the hedge we need here is a full one, not just 30% or 50% or whatever we might be told we should choose.
As it turns out, the advice we get from our advisors tends to be pretty terrible actually, starting from the idea that we should restrict ourselves to mindlessly managing things. If we do choose to do this though, we at least need to choose a fixed and static strategy that makes more sense rather than less or none.
Diversification May Be Needed, But We Should Not Dilute Things Too Much
Another thing that we get bad advice on is the need for diversity. If we are managing our positions actively, the goal needs to be to minimize this. Diversity, like hedging, does come at a price, and that price is similar to what bonds or low beta stocks do, which is limiting our returns. We can hedge our positions much more effectively by just getting out of them when we should rather than hanging on and taking the losses and looking to water them down through diversification.
If we do insist on clinging to our positions come what may, then it can be wise to mix things up a bit anyway, to look to reduce the risk of a particular stock or sector encountering an above average amount of suffering. If our positions are underperforming, we shouldn’t be in them anymore, but if our mindless approach requires this, holding something else not doing as badly does beat just holding our suffering position and taking the full measure of it.
This is therefore at best a compensatory mechanism, seeking to reduce risk by preferring a bad approach over one even worse, but the real problem lies in the degree of diversity that we are supposed to be shooting for. The more we add, the more we water down our returns as a general rule, if we imagine that there are a hierarchy of choices when we pick stocks and the deeper that we go down the list the more diluted our performance will become.
We mix up our portfolios based upon beta as well, where we might want to put a certain percentage in higher beta ones like Apple or Amazon, some in average beta stocks, and some in lower beta ones such as utility stocks, which don’t go down as much as the market does typically.
If we aren’t going to manage our positions, for instance moving in and out of sectors as the conditions dictate, like going big with the tech stocks when they are running and running the other way when they are not, then we should at least be doing something instead. When the high beta stocks have their day, we will get a portion of this to spice up our returns, and when they hit the skids, our losses become watered down by lower beta stocks.
Utility stocks in particular are comparatively immune from the business cycle, as the demand for what they sell doesn’t vary that much. We need electricity for instance during both good and bad economic times, where with some other things, demand for them may be more sensitive to the economy.
Some Utility Stocks Do Well at Both Defense and Offense
It can therefore make sense for us to be in utility stocks in certain times, especially during bear markets, even though a lot of the time during a bear market it’s just better not to be in stocks at all. If your utility stocks have lost only half what the market has, you still have lost, and it’s never wise to choose a path that provides a negative expectation even though it may be a lesser one.
Some see utility stocks as too tame though, but like all stock sectors, there are different qualities of stocks out there. Some utility stocks are better than others and some may actually be a great choice overall if we’re just planning on holding stocks through any weather.
If we find something that performs competitively with the market during the good times but only has half the risk, in other words it only goes down about half as much during bear markets, this would be a real find indeed. There are some utility stocks out there that can make this claim, which buy and hold investors would be very well advised to consider.
They don’t go toe to toe with the Apples and the Amazons during bull markets, but they can keep up with the market during the good times, and beat both during the bad times. Overall, and overall is what matters when you are just holding stocks long-term, they can also beat both quite handily, and this is the real advantage of them.
Utility stocks are more known for their higher dividends, although dividends are just a bonus with common stocks, as most of the potential return of common stocks is its capital appreciation. Some utility stocks appreciate in price quite nicely though, and in a way that should really grab the attention of buy and hold investors who are seeking good returns while keeping risk down.
Xcel Energy is one of these stocks. They are up 20% year to date, twice the return of the market, and this has been a pretty bullish year for the market by normal standards. Perhaps even more noteworthy is the fact that Xcel actually went up a bit last month, while the market famously lost 6%.
This is the time where a stock like Xcel really shines. Who cares about the trade war in China as long as people in the Midwest still need electricity and natural gas. The economy may be slowing a bit but the people there still need to power their homes regardless.
Perhaps we may be thinking that this is some sort of anomaly, and while it is to be expected that a utility isn’t going to be subject to anywhere the same market risk or downside in general that most stocks are, we’re supposed to pay a pretty big price in performance.
The last 10 years have been a fabulous bull run for stock markets of course, and while a lot of money was lost during 2008, it eventually recovered as most thought it would and we’re a lot higher now in 2019.
Let’s look at how the S&P 500 performed from its peak of 1561.80 in October 2007 until now, and do the same with Xcel Energy. We won’t even count Xcel’s dividends over this time, although that does add to its appeal and overall returns as they do pay out some very nice ones, in the range of 3-4% per year historically.
The S&P has gained 82% since then, which works out to 7% per year. That’s pretty impressive, and something we would not expect Xcel Energy to be able to compete with in terms of the growth of its stock price at least, since it’s a utility after all. Sure, it didn’t go down as much during the crash, but given the way that these stocks plod along, being in the S&P all this time should produce much better returns, or we would think anyway.
Xcel Energy traded at $21.73 back in October 2007. It did go down during the next year and a half like just about everything did, and this was simply a terrible time for stocks period. At its lowest, in February 2009, it dropped to $16.57. That’s a 24% dip at its maximum, and while this is nothing to sneeze at, it does show that how muted the downside is with this stock.
The S&P 500 gave back 58% during this crisis, so in comparison, this 24% looks pretty nice indeed. It wasn’t until March of 2013 that the S&P got back to where it was before all this started, where Xcel got back to its starting point two years earlier. By the time the broader market got back to October 2007, Xcel wasn’t just even, it added another 39%.
During the dip between October 3 and December 24 of 2018, the S&P lost 20% of its value. Not only did Xcel Energy not go down during this time, it actually gained 5% during these 3 months, which works out to an annualized return of over 20% during the worst pullback we’ve seen in 10 years. That’s impressive, especially if you don’t like 20% drops in your portfolio.
This is what you really call hedging risk. However, the most impressive part of all this may be the way that Xcel has beaten the overall market since 2007. The S&P’s 82% might seem hard to beat, but over this time, Xcel Energy has gained 176%, not only beating the market but more than doubling it.
This is what you call a real hedge, one that not only reduces the risk of drawdowns as hedges are supposed to, but also provide better returns overall in all weather, much better in fact. This stock has proven to be such a good hedge against the market that the hedge itself beats the market on all counts, and we might even wonder why we would want to have most of our money in inferior positions all around and not put a whole lot more in the so called hedge.
At the very least, if we’re looking to offset our index fund positions or other baskets of stocks with something, so that when the bear market comes less blood will be shed, a utility stock like Xcel Energy makes a lot of sense and has much to offer. As long as the company continues to do well, and this is a solid company indeed, it can beat the market at its own game of capital appreciation, really reduce our risk, offer better nominal returns overall, and also pay out those nice dividends as a bonus, a sweet deal indeed.
Sometimes the tortoise does beat the hare in real life, if you bet on the right one that is.