Can Utilities Keep It Up?

6/30/2014


With the 2014 stock-market race nearly half over, utilities enjoy a comfortable lead. The S&P 500 Utility Sector Index has returned 16.4% in 2014, tops among the 10 market sectors and more than twice the broader index's 6.4% return.

When a sector known for stodgy, high-yield companies becomes so fleet of foot, we take notice — especially because utilities are distinguishing themselves by more than their price action. The average utility stock in the S&P 1500 earns a Quadrix Overall score of 67, the highest of the 10 sectors and well above the index average of 61. Last month marked the first time the sector has managed an Overall score of 67 since the index's inception; not in 20 years have utilities enjoyed such strong fundamentals.

On average, utilities lead all sectors in Momentum (62), Value (69), Earnings Estimates (64), and Performance (68) score. The sector has averaged more than 60 in four of the six Quadrix category scores just twice in the 235 months since the end of 1994 — May and June of this year.

With utilities' Overall scores unusually high, more of them come up in our stock screens than ever before. So why aren't we adding more utilities to our recommended list? Here are four reasons:

• Those superior fundamentals come at a price. Utilities' average Value score of 70 may be tops in the S&P 1500, but it's in line with the long-run average for the sector, which has historically traded at a discount to most other sectors. Utility stocks look pricey relative to historical norms in the wake of this year's strong returns, averaging price/earnings ratios of 18 (higher than 79% of the months since 1994) and price/book ratios of 1.9 (66%). The average utility's price/sales ratio of 1.7 is near a record high, topping 98% of historical periods.

• Two decades of history suggest utilities won't hold their lead. Over the last five years, the S&P 500 Utility Sector Index returned an annualized 15.1%, ranking eighth out of 10 sectors and lagging the broader index's 18.7%. We used the S&P 500 rather than the 1500 to make this point because we have a full 20 years of history for the large-cap index. During that period, the utility sector's 8.2% annualized return also ranks eighth out of 10. The stock market tends to penalize utilities for their low growth and weak balance sheets over long periods of time.

• The harsh winter boosted profits for many utilities in the last two quarters, making for stronger growth comparisons. If temperatures revert to normal levels, the group's operating momentum could recede quickly.

• The sector's long-term growth picture doesn't look any better than the near term. Utilities' Momentum score, which measures operating results within the past year, may top the index. But their historical average is 46, which would rank ninth among the 10 sectors today. Given the past/present dichotomy and utilities' average five-year profit-growth estimate of 5%, lowest of any sector, we expect the sector's Momentum scores to drop in coming quarters.

At the moment we recommend just one utility — UGI ($49; UGI), which earns Buy and Long-Term Buy ratings. Investors looking for more utility exposure should consider our Top 15 Utilities portfolio (www.DowTheory.com/Go/Top15). We are making a change in the portfolio today.

Empire District Electric ($25; EDE) is replacing Southwest Gas ($52; SWX). Empire District, fresh off two quarters with at least 15% sales growth and 52% per-share-profit growth, trades at 15 times trailing earnings, 6% below its five-year average. The company serves 169,000 electricity customers and 44,000 natural-gas customers, mostly in Missouri. Southwest Gas delivered a negative total return of 5% so far this year, by far the worst in the Top 15. Profits have declined in each of the last two quarters and fallen short of the consensus in the last three.

HISTORY DOESN'T FAVOR UTILITY SECTOR
While utilities are leading the pack this year, over the last five- and 20-year periods, the S&P 500 Utility Sector Index has lagged the broader index and finished eighth among the 10 sector indexes.
--------------------------------------- Total Return ---------------------------------------
S&P 500 Sector
Year-
To-Date
(%)
Sector
Rank
5 Years
(Annual.)
(%)
Sector
Rank
20 Years
(Annual.)
(%)
Sector
Rank
Energy
12.0
2
15.4
7
13.0
1
Health care
9.8
3
21.1
3
12.9
2
Technology
7.6
5
19.3
4
11.2
3
Consumer staples
5.2
6
17.6
5
10.6
4
Industrials
4.0
9
21.7
2
10.5
5
Cons. discretionary
(0.7)
10
25.6
1
9.8
6
Materials
7.6
4
16.4
6
8.3
7
Utilities
16.2
1
15.1
8
8.2
8
Financials
4.8
7
15.1
9
7.7
9
Telecom services
4.4
8
14.8
10
5.6
10
S&P 500
6.4
18.7
9.7

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