Utilities Don't Look Their Best

6/29/2015


Down 9.8% so far in 2015, the Dow Jones U.S. Utilities Index is the worst-performing sector index. This year's rise in interest rates is only partly to blame.

The sector entered 2015 with stretched valuations. Utility stocks in the Dow Jones U.S. Index traded at nearly 20 times trailing earnings, a 19% premium to the sector's average P/E of 16.6 since 1995. Today, the P/E is 17.9.

With the Federal Reserve expected to raise interest rates this year, bond yields have bounced higher. Higher yields increase the relative attractiveness of bonds, tempering enthusiasm for dividend-paying stocks, particularly utilities.

As a group, utility stocks aren't too appealing. But investors sometimes overdo their pessimism.

For one thing, though utility stocks generally underperform when rates are rising, the sector still fares reasonably well. Consider the table below, which shows the average return for utility stocks in the Dow Jones U.S. Index in periods of rising interest rates over the past 25 years. Utilities outperformed the broad index during the most recent period of rising rates and had pockets of strong gains in the period ending July 2000.

PERFORMANCE WHILE RATES RISE
Utilities in the Dow Jones U.S. Index have had mixed success in periods of rising interest rates over the past 25 years. The sector beat the broad index during the most recent upturn.
------------------- Avg. Returns When Interest Rates Rise -------------------
Time Period
Electric
(%)
Gas
(%)
Water
(%)
All
Utilities
(%)
Dow Jones
U.S. Index
(%)
Dec. 2003 to July 2007
50.2
53.5
67.3
50.1
43.0
June 1999 to July 2000
4.7
14.0
18.8
7.1
9.5
Dec. 1993 to April 1995
(3.0)
3.2
(2.3)
(1.6)
11.7

While utility stocks remain expensive versus their own history using P/E ratios, the sector seems reasonably valued relative to bond yields. The top chart below shows the group's earnings yield, or earnings/price ratio, relative to government and corporate bond yields.

For example, the recent earnings yield of 5.6% is 132% higher than the 10-year Treasury yield of 2.4%, outstripping the average premium of 64% over the last 20 years. The earnings yield is at a 10% premium to Baa-rated corporate bonds, versus a discount of 7% over the past 20 years.

Relative dividend yields paint a similar picture. Utilities yield an average of 3.5%, a 45% premium to Treasury-note yields — well above the 20-year norm of a 6% premium.

Look for rebound plays in Quadrix

While the utility sector has come back to earth after an impressive 2014, smart investors can benefit from sifting through the group for high-potential stocks. Our Top 15 Utilities Portfolio is home to several Quadrix® standouts, including these two timely picks:

Public Service Enterprise Group ($40; PEG) earns an Overall rank of 84 and scores of 93 or higher for both sector-specific scores. The company operates mostly in mid-Atlantic and Northeastern states. Trading at 14 times trailing earnings, Public Service yields 3.9%.


WGL's ($55; WGL) Overall score of 86 places it second among the 22 natural-gas utilities in our research universe, which earn an average score of 55. The stock boasts particularly strong scores for Momentum (84) and Value (74). Up 2.6% so far this year, WGL yields 3.4%.


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