Inflationary pressures can be hard on the values of stocks. For investors interested in long-term, income-focused investments, well-chosen utility stocks can provide solid returns. Over shorter periods of time, however, inflation can also cause utility stock prices to drop.
For a large portion of companies in the utility sector, rates for electricity and gas services are regulated by state utility commissions. These commissions set prices to allow electricity and gas providers to earn a specified return over the costs of generating energy and the capital the companies invest in plants and equipment. If costs for utility companies rise due to inflation, these companies will usually be granted rate increases to cover the higher costs and still provide an attractive return to investors. Because the effects of inflation are passed along to customers, investors in utility stocks are protected from shrinking profit margins.
Yields Reflect Rising Prices
Investors buy utility stocks primarily to earn an attractive dividend yield. If inflation heats up, interest rates on other yield-focused investments will rise. As a result, if interest rates increase significantly, the share prices of utility stocks will typically drop, which increases the yield. Utility stock investors will continue to earn the dividends that attracted them to these investments in the first place. However, an investor should not be surprised that the shares prices of his utility stocks decline when interest rates start to increase and then see the share prices stabilize when interest rates find a new level of stability.
Steady Dividend Growth
Unlike comparable fixed income investments such as long-term bonds, utility companies typically have histories of regular, annual dividend increases. Over a several-year investment period, a growing dividend will help pull up the share price of a quality utility company. The effects of inflation on the rates utilities get to charge their customers may allow these companies to increase dividends at a faster rate than the increases that would be allowed during periods of low inflation.
Moderate Inflation Can Benefit Stocks
Periods of high inflation are tough on all types of companies. Prices of materials increase faster than companies can raise the prices charged for their products. This hurts profit margins, which could cause stock prices to decline. However, stocks tend to perform pretty well during periods of moderate inflation. Companies can increase their prices faster than input costs and increase their profit margins. In this type of price environment, utility stocks provide a conservative, income paying investment choice where the focus would be on a growing stream of dividend payments.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.