Are utilities defensive stocks?

Oil pipes in an oil field

Many investors talk about defensive stocks. Those are shares that may be less subject to the ups and downs of the business cycle than others. For example, they may sell services the essential nature of which will lead to ongoing customer demand, whatever the economic environment.

In reality, all shares are subject to price movements. But, for example, we all need water and energy. Built-in demand could keep revenues for the utilities that provide them fairly steady.

Utilities and recurring revenues

Typically a utility enjoys a monopoly of some sort. Installing the necessary infrastructure like pipelines or transmission masts is highly capital-intensive. That alone often means that there is little or no chance of competition. So not only is a utility’s revenue likely to be fairly stable, but it is also in a position to be very profitable. That is one of the attractions of utilities to me.

This logic does not apply equally to all utilities, however. In fact, demand for a service like energy provision can vary a lot. One reason the Centrica share price remains low is that many investors fear natural gas will be phased out altogether as an energy source in the UK. That is why, if investing in utilities, I would be tempted to consider a company that I think looks set to thrive in future. While energy sources may change, I see no real alternatives that could usurp the role of water in everyday life. While demand may fluctuate, people will be using water forever.

The difference between a business and its shares

Another mistake some investors make is confusing defensive businesses with defensive shares.

A company’s share price reflects what people are willing to buy or sell it for. In some cases that can be far detached from what a business might be actually worth. That is true for utilities, just like any other shares.

Consider SSE as an example. Back in September, I could have bought its shares for around £11.70. But currently they trade about 38% higher. That is not what I would regard as stable. I think the price movement reflects investor sentiment more than a shift in the company’s underlying business prospects.

But it does show that utilities can sometimes offer attractive capital gains, despite their rather dull reputation. That can be in addition to a tasty yield — SSE, for example, currently yields 5%. Yet it also emphasises the need for me to pay attention to the share price of a utility when assessing whether to add it to my portfolio. Just the fact that it is a defensive stock doesn’t necessarily make it a good choice for me.

My take on defensive stocks

Utilities often lack diversification and investing in a single share is always risky – even utilities can go bust. But I would be happy to hold several utilities in my portfolio as part of a diversified group of stocks. I’d pay attention to the share price and also to my judgment of the company’s likely future business prospects, just like I would for any other type of share.

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Christopher Ruane owns shares in Centrica. The Motley Fool UK has recommended National Grid. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.