This month at The Motley Fool we've dedicated ourselves to getting back to basics, culminating on September 25 with Worldwide Invest Better Day. With this in mind, my Foolish colleagues and I are opening the floodgates and unleashing vital information to help you invest better. In a previous article, we reviewed stock diversification, a key fundamental of investing. One by one, we'll take a look at the various stock sectors, focusing today on utilities.

Oft-considered-boring utilities stocks are viewed as a defensive investment during an economic slowdown primarily because electricity, natural gas, and water are considered basic essentials. Consequently, utilities -- like consumer staples and telecom -- are less susceptible to the economy relative to other sectors, namely consumer discretionary and tech. Using the MSCI World Sector Weightings as a benchmark, approximately 4% of your overall stock portfolio should be allocated to utilities.

How utilities perform
Over long periods of time, utilities are consistent performers. In the past decade, the utilities sector returned 177% versus 103% for the S&P 500. Even though no sector was safe during the most recent recession, utilities held up better than the overall stock market losing 41% compared to the S&P 500's nearly 55% decline from October 2007 to March 2009. That being said, utilities stocks typically lag behind when the stock market is humming. During the recent stock run-up, which commenced in March 2009, utilities returned roughly 85% versus 128% for the market.


Why utilities?
Most investors buy utilities stocks for their dividends. With the Federal Reserve pointing to low rates for the foreseeable future, utility stocks will continue to be an attractive option for income-hungry investors. Look for utilities that consistently increase their dividends; this can help you offset the effect of inflation. Without increases, dividend income loses its purchasing power, which can negatively impact your standard of living over time. All four of the utility companies below have increased their dividends at a rate higher than that of inflation.

Company

Dividend Yield

Dividend: 5-Year-Growth Rate

Payout Ratio

PPL (NYS: PPL) 5.0% 4% 48%
Public Service Enterprise Group (NYS: PEG) 4.5% 3% 53%
NextEra Energy (NYS: NEE) 3.5% 7% 45%
Aqua America (NYS: WTR) 2.7% 7% 59%

Source: The Motley Fool

Also, focus on companies with low payout ratios, indicative of dividend growth potential. High payout ratios indicate less cash that the company has to increase dividends. These four companies pay in line with or slightly less than the sector's average payout ratio of 55%-60%.

Challenges and trends for the sector
Many utility assets in the U.S. are old and in need of repair or replacement. Also, EPA regulations may force many coal-fired power plants to install expensive equipment and technologies. Some electric utility providers may find it too costly and choose not to retrofit outdated equipment. A possible loss of capacity could result in an increase in the cost of power. Companies that derive their power generation from non-coal-fired plants, or those already retrofitted, will benefit. One such company is Exelon (NYS: EXC) , the nation's biggest electricity generating company. It's the largest owner and operator of nuclear power plants in the U.S. and also generates electricity from fossil, hydro, and renewable energy sources. Through Exelon's diversified business, it delivers electricity and natural gas to more than 6 million customers.

Environmental concerns help drive increased investment in renewable energy. When it comes to renewable energy, NextEra is the largest U.S. generator of wind and solar power. The company recently partnered with General Electric to acquire a 550-megawatt solar farm in sunny Southern California, and plans to expand its total electricity capacity from wind by 14% in 2012.

Different ways to own the sector
If you're ready to load up on utility stocks, consider diversifying across the sector. One way to do this would be to include diversifying geographically -- where the utility is located. This will reduce regulatory risks and weather perils, two challenges facing this sector. Also, think about diversifying across different types of utilities -- electric, natural gas, water, and renewables.

If instead you're interested in a simpler solution, then consider exchange-traded funds, or ETFs. ETFs mimic the performance of an index, like the S&P 500, or provide specific exposure to certain sectors. Sector-specific ETFs like Utilities Select Sector SPDR ETF are helpful when you lack information to hypothesize an investing thesis.

You: a better investor
If you bet wrong in the stock market, it could cost you severely. Instead, develop a long-term strategy for adding all sectors to your portfolio. That way, regardless of what happens in the stock market, you can sleep well at night knowing a portion of your portfolio will triumph.

Join us for more investing basics on our microsite for Worldwide Invest Better Day. On the site, we've posted a plethora of articles aimed at helping you become an even more excellent investor.

The article An Investor's Guide to the Utilities Sector originally appeared on Fool.com.

Fool contributor Nicole Seghetti owns shares of NextEra Energy. She welcomes you to follow her on Twitter @NicoleSeghetti. Motley Fool newsletter services have recommended buying shares of Aqua America and Exelon. Motley Fool newsletter services have recommended creating a write covered straddle position in Exelon. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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