Don't Panic Over Weak Utilities
Since the end of June the S&P 1500 Utility Sector Index has returned 1.7%, ranking ninth among the 10 sector indexes. The utility sector has declined since March, one of just two sectors to fall. On average, utility stocks in the S&P 1500 Index earn Quadrix Performance scores of 29, more than 20 points below the index average.
Several factors explain utilities' sluggishness, including:
• Weakness in high-yield stocks: S&P 1500 Index components that yielded at least 3% at the end of June averaged returns of 4% since then. High-yielders have returned 5% since March and 15% over the last year. As the chart below illustrates, stocks with lower yields averaged substantially higher returns during all three periods. The underperformance of high-yielders reflects higher tax rates on dividends and the specter of rising interest rates, as high-yield stocks tend to underperform when rates increase. Utilities in the index average yields of 3.7% today versus 3.8% a year ago.
• High valuation: The utility sector index trades at 17 times trailing earnings, an 18% premium to its five-year average valuation. The broader S&P 1500 is just 3% above its five-year norm. At 15.5 times projected earnings for the year ahead, the utility sector index trades roughly in line with the broader index despite far lower profit-growth potential. Which leads us to â€¦
• Subpar growth: The consensus projects per-share-profit growth of 7% for the S&P 1500 Utility Sector Index over the year ahead, the lowest of the market's 10 sectors and less than half of the broader index's projected 17% growth. Relative to year-ahead earnings, utilities look more expensive than energy, financials, or technology, sectors expected to deliver double-digit profit growth over the next 12 months.
Of course, we're not ready to write off utility stocks yet. Over the last 15 years, the S&P 1500 Utility Sector Index returned 159%, versus 145% for the broader index. And while utilities have lagged the market in three of the last four calendar years, they delivered a superior return in each of the five years before that.
Are we excited about the prospects of utilities over the next year? Not especially. But utility stocks average Quadrix Overall scores of 56, and while the sector's profit growth is subpar, utilities stack up fairly well versus the rest of the market based on valuation. Thus, income-oriented investors shouldn't necessarily shy away from the sector. Rather, they should be judicious in their choice of utilities, selecting a diversified mix of stocks rather than relying on just one or two.
If you wish to own utility stocks, check out our Top 15 Utilities portfolio, presented in the table below. So far this year, the portfolio has returned 18.8%, versus 12.9% for its benchmark, the S&P 1500 Utility Sector Index. Since the start of 2007, our utilities have returned 83.0%, outperforming the index by more than 41 percentage points.
Today we're making two changes in the Top 15 Utilities portfolio.
AGL Resources ($47; GAS) and New Jersey Resources ($45; NJR) are being added to the portfolio, where they have spent time in the past. In both cases, we dropped the stocks in part because of a lack of growth. Now they have regained their stride.
AGL has underperformed the sector since we removed it from the list in 2011. But things are looking up for the utility, which serves 4.4 million customers in Georgia, Virginia, Tennessee, New Jersey, Florida, and Illinois. The acquisition of Nicor drove much of AGL's robust sales growth, with gains at least 21% in each of the last six quarters. But profit growth was spotty until the last two quarters. Per-share profits rose 23% in the June quarter and 13% in the March quarter, and AGL seems to have absorbed the last of its merger-related costs.
At 16 times projected earnings for 2014, AGL trades 3% below the median gas utility in the S&P 1500 Index. AGL's dividend yield of 4.0% is above the sector average of 3.7% and the average of 3.6% for gas utilities. With some of the lowest operating costs in the industry and several nonregulated storage projects coming online next year, AGL seems capable of exceeding the 5% profit growth expected in 2004.
New Jersey Resources earns a Quadrix Overall score of 93, the highest in the sector. Scores of 94 for Momentum and 96 for Earnings Estimates are also the sector's best, reflecting impressive growth in the first half of the year. In the nine months ended June, New Jersey Resources' per-share profits rose 31%, helped by strong results at the nonregulated storage and transportation unit. The company provides natural-gas service to about 500,000 customers in New Jersey, benefiting from both modest growth in the customer base and a trend toward conversions to gas heat. With gas prices at historically low levels even after the recent recovery, the outlook for natural-gas heat remains solid.
New Jersey Resources trades at 18 times trailing earnings, 3% below the natural-gas utility median and 9% below its own five-year norm. The stock also looks cheap versus its history based on price/sales and price/book ratios. The company targets annual profit growth of 6% to 7% and dividend growth of 5%, and the shares seem reasonably valued relative to their growth potential. The consensus projects profit growth of 5% next year, and the company raised its profit targets earlier this month.
Despite declining sales, shrinking profit margins, and earnings that missed estimates in the last two quarters, OGE Energy ($36; OGE) shares have been among the top performers in the industry this year. Factor in a high valuation, and we see a recipe for future underperformance. While American States Water ($27; AWR) still looks cheap relative to its water-utility peers, it has become pricey relative to its slowing operating momentum. Facing heavy spending to upgrade old water networks and consensus estimates of relatively flat profits this year and next year, we see little room for outperformance. OGE and American States are being downgraded to B (average) in the Utility Update.