What's Working With Utilities
Long-term averages can be deceiving, particularly for areas undergoing transformative change like the utility sector.
Some of the valuation tools with the best records based on long-term average returns, including P/E ratios and Quadrix Value scores, have not worked well with utility stocks over the past five and 10 years. Buying utility stocks with high dividend yields — a popular strategy that has delivered modest outperformance since 1994 — has not worked over the past decade and has been horrible over the past two years.Â
In the past 12 rolling 12-month periods, the one-fifth of utilities in the S&P 1500 Index with the highest dividend yields underperformed the index's average utility by 7%, on average. Over that stretch, dividend yield ranked 192 out of the 196 factors we track. P/E ratio was nearly as bad, with the cheapest quintile underperforming by an average of 4%. Neither factor has proved particularly effective over the past 10 years, either.
Utilities behave differently than other stocks in Quadrix when it comes to valuation statistics. For the S&P 1500 as a whole, the Value score has been by far the most effective factor in Quadrix over the past one, five, and 10 years. The same is true within most of the 10 S&P 1500 sectors. But the Value score was by far the worst Quadrix category for utilities over the last 12 rolling periods — and fairly ineffective over the last five and 10 years. Yet Value still ranks as the best-performing category score since 1994.
As utilities have come to be viewed more as operating companies and less like bond substitutes, other measures have begun to work better in the sector. Quadrix Overall and Momentum scores have worked nicely over the past one and 10 years. Interestingly, one of the few valuation ratios with a consistent record of utility-sector success in recent periods, PEG ratio, considers value relative to expected growth. The PEG ratio (forward P/E divided by estimated five-year growth in earnings per share) ranks among the best of all Quadrix variables in the sector over the past one, five, and 10 years.
Implications for investors
Valuations play a big role in our utility recommendations. But focusing solely on valuations and yields is a mistake, as growth prospects for utilities vary widely nowadays. Subscribers should look for attractively valued utilities that also have sufficient growth potential to drive share-price appreciation. Our Top 15 Utilities portfolio, shown in the table below, contains several such stocks.
Investors seeking utility exposure beyond the single stock — UGI ($46; UGI) — on our buy lists should purchase equal-dollar amounts of the 15 companies. The Top 15 portfolio has returned 10.0% this year, versus 12.2% for the S&P 1500 Utility Sector Index. But the portfolio has outperformed in six consecutive calendar years, returning 112.6% since its January 2007 inception versus 61.4% for the sector index.