Investors focus too much on growth and too little on stability. However, it is prudent to have defensive stocks as well in your portfolio to diversify.
A classic defensive stock
Growth stocks offer higher potential returns against higher risk. But defensive stocks provide dividends and act as a hedge when markets turn volatile. And that’s why stability is more important in long-term investing, even if one has to sacrifice a few percentage points of return. Top utility stock Algonquin Power & Utilities (TSX: AQN)(NYSE: AQN) is one such TSX stock.
It is a $12 billion utility that distributes natural gas and electricity and also operates renewable assets. The company makes a significant portion of its earnings from regulated operations, which offer earnings stability and predictability. It also has significant exposure to renewables assets.
While regulated operations offer it earnings stability, renewables provide growth. That’s why Algonquin has seen a remarkably higher earnings growth in the last few years than peers.
Earnings stability and large renewable assets
Algonquin’s net income has increased from close to $85 million in 2015 to $782 million in 2020. Utilities generally exhibit low, single-digit earnings growth. But Algonquin has outperformed peers on the earnings front by a wide margin. The same was reflected in its stock price as well. It has returned almost 600% in the last decade, where Fortis (TSX: FTS)(NYSE: FTS) returned just 135%, while Canadian Utilities (TSX: CU) stock returned 81%.
Algonquin stock lags peers when it comes to the dividend yield. It yields 3.9%, lower compared to the industry average. Algonquin increased by 10% compounded annually in the last decade.
Last year, it gave away only 33% of its earnings as dividends. Algonquin’s payout ratio is notably lower than peers. It indicates that there is a huge scope of dividend increase over the long term. Fortis had a payout ratio of 67%, while Canadian Utilities had it at around 127% in 2020. CU’s greater than 100% payout ratio indicates that it distributed more in dividends than it earned last year.
Notably, FTS and CU also have solid dividend profiles and have some of the longest dividend increase streaks in Canada.
Utilities generally have a higher payout ratio. Predictable requirements of capital expenses allow them to give away a large portion of their earnings to shareholders.
Why utilities?
Utility companies remain relatively stable, even in a market downturn. Their earnings are not susceptible to business or economic cycles. Thus, AQN will likely continue to generate similar earnings, and one can expect consistent dividends from it, even in case of an economic shock.
Algonquin plans to invest US $9.4 billion in capital projects through the next five years. Investors can expect consistently growing dividends from AQN for the next few years, driven by its earnings stability and superior renewables portfolio.
Bottom line
AQN stock was relatively faster to recover from the pandemic crash last year. It has soared 18% in the last 12 months, while Fortis and CU stocks have surged 8% each. Interestingly, AQN is still trading at a relatively discounted valuation against peers, suggesting a continued upward rally.
I agree that utility stocks can be boring because of their slow stock price movements. However, they can generate decent returns with relatively lower risk. Even if you are an aggressive growth investor, it makes sense to hold stocks like Algonquin to protect the portfolio from volatility and recessions.
