An Alternative Way To Play The AI Boom

The world of stock analysts and commentators, as seen in the financial media, has been abuzz this week with one big story. The Fed are conducting their annual get together at Jackson Hole, there are some worrying stories of economic issues out of China, and there is a curious sudden problem with, or at least admission of “shrinkage”, aka massive theft, in retail. These and countless other stories are getting mentioned, but the media has been dominated this week by one story…the build up to, release of, and analysis of, Nvidia (NVDA)’s second successive quarter of blowout earnings. You may wonder why I mention that here, given that this is a venue dedicated to all things energy-related, but it and the story behind the story have some significance for the sector that is being largely overlooked.

The AI Revolution is Real

Energy investors tend to be conservative by nature, and most are probably therefore skeptical about talk of “the AI revolution”. They will have a sense of deja vu, having seen similar things come and go in their own space many times. Fuel cell stocks, for example, have been the next big thing on more than one occasion, but stocks like PLUG, FCEL and BLDP are back down in the basement right now.  Nvidia’s last two quarters, however, have shown that the AI thing is not just hype and hyperbole. The saturation coverage may make you instinctively feel that way, but the numbers tell you that, at least in Nvidia’s case, AI is a real generator of massive income and profit.

The Impact on the Energy Sector

The thing is though, all of that computing takes power, and power provision is what the energy sector is all about. However, the part of the market that is all about energy production, the utilities sector, has been under pressure for some time. That is not due to the long-term projections for growth in electricity demand, though, it is about the relatively short-term impact of rate hikes.

That is understandable. After all, utility stocks typically derive a good portion of their value from the dividends they pay, and those dividends look a lot less attractive when investors can get a five percent yield on US government bonds, the thing regarded by the global financial system as the definition of a “safe” investment. However, there are times, and this is one of them, while the yield on utilities still matters, the case for owning them rests on the possibility of capital appreciation.

Dividends Are Still Important

Even though the market as a whole is not keen on the value of utility dividends, dividends in general are an important part of any long-term investment.

The above chart, taken from a report by The Hartford, shows the difference in outcome from $10,00 invested from 1960 to 2022 in the S&P 500, with and without reinvested dividends. And that, remember, is from the S&P 500 where yields have been significantly lower historically than they are in utility stocks.

The Growth Case

Under normal circumstances, the advantage that utilities have in terms of dividend reinvestment would be at least partially offset by a lack of price appreciation in comparison to other stocks. Right now, though, with utilities depressed because of the interest rate situation and the AI boom adding to the electricity demand surge already coming from the shift to EVs, that isn’t the case. In fact, a good argument can be made that utility stocks offer some of the best fundamental growth opportunities around. It may not be the triple-digit explosion that NVDA is currently posting, but it will be consistent whoever wins the AI war, and significant nonetheless.

The conventional metrics tend to support that value proposition. P/Es aren’t crazy low, but they are typically below market averages, which, given the expected growth in the addressable market, does represent good value.

How to Play It

As always with a sector or industry play like this, the simplest, and probably safest way of playing the idea is by buying an ETF. In this case, that would be the SPDR Utility Sector Fund (XLU). That makes sense in a lot of ways given that this is a play on an industry, not a company. The only downside to that, however, is that XLU “only” yields just over 3%. That is a good dividend yield in any other context, but not great for a utility investment.

For that reason, I would split my investment between XLU and a couple of individual stocks with higher yields. My picks would be Southern Company (SO), which has slightly outperformed XLU this year and yields just over 4%, and Dominion, which has underperformed YTD but yields over 5%. Reinvesting those dividends, which equate to an average 4% or so in overall yield, will provide some protection should utilities stay a bit depressed for a while. But at some point, the real value of power generation in a world where Nvidia’s products are sucking up increasing amounts of electricity will be reflected in utility stocks.

Utilities may not be trendy and sexy like NVDA, but that sexiness will result in huge demand growth in the power business. As the impact of that inevitably filters through to the stocks of utilities, buying and holding some of those out-of-favor stocks will prove to have been a smart investment for those who are more concerned with long-term performance than short-term sexiness.