Seven Reasons To Own Utilities

12/28/2015


Want to push an investor's buttons? Trash utility stocks, and you'll find they tend to inspire strong opinions.

Many income-oriented investors love utilities because of their robust dividend yields and perceived safety. On the other hand, investors who seek growth may dismiss the sector outright because utilities, which depend mostly on government-regulated income streams, don't usually generate market-beating sales and profit gains.

UTILITIES VERSUS THE FIELD
All numbers below are averages for S&P 1500 Index stocks except for the percentage of stocks paying dividends and the percentage scoring above 80 or 90 Overall.
Utilities
Rest of
S&P 1500
Index
Dividend
Yield (%)
3.5
1.8
Yield, excluding nonpayers (%)
3.6
2.6
5-year annualized growth (%)
5
13
% of stocks paying dividends (%)
98
63
Volatility
Standard deviation (%)
5
10
% of down months, last 5 years (%)
42
44
% of years with positive returns, last 5 years
Growth
Sales, 12 months (%)
(1)
5
Per-share profits, 12 months (%)
2
4
Sales, 3 years annualized (%)
3
6
Per-share profits, 3 yrs. annualized (%)
4
7
Sales, 10 years annualized (%)
2
8
Per-share profits, 10 yrs. annualized (%)
3
7
Estimated EPS growth, current year (%)
(1)
3
Estimated EPS growth, next year (%)
4
13
Est. EPS growth, next 5 yrs. (ann.) (%)
6
12
Valuation
Trailing price/earnings ratio
18
21
Versus 5-year average
1.04
0.97
Trailing price/sales ratio
1.8
2.5
Versus 5-year average
1.14
1.03
Trailing price/book ratio
1.8
2.7
Versus 5-year average
1.05
1.00
Price/earnings-to-growth (PEG)
3.1
1.6
Total return
3 month (%)
5
1
6 month (%)
6
(9)
12 month (%)
(1)
(4)
3 year (annualized) (%)
12
11
10 year (annualized) (%)
11
9
Quadrix
Momentum
53
50
Value
61
56
Quality
43
64
Financial Strength
60
58
Earnings Estimates
53
47
Performance
65
54
Overall
57
59
% With Overall Above 80
7
20
% With Overall Above 90
2
9
Notes: Quadrix scores are percentile ranks, with 100 the best.  Averages may exclude some outliers.

The true picture is less clear than the surface arguments imply, as the table above illustrates. Drawing on that table, as well as our longtime coverage of the utility sector, below we present seven reason to own utilities — as well as reasons not to load your portfolio with them.

In favor of utilities

1) Current income. Utilities in the S&P 1500 Index average yields of 3.5%, with all but one paying dividends. Outside of the utility sector, index stocks average 1.8% yields, with more than one-third paying no dividends. Even if we ignore nonpayers, utilities still deliver better yields, 3.6% versus 2.6%.

2) Less-volatile returns. Standard deviation measures the dispersion of a security's returns around the average. Over the last 10 years, a period spanning 120 months, the index's utility stocks averaged standard deviations of 5%. A 5% standard deviation implies that two-thirds of the time, monthly returns were within 5% of the average return. In contrast, nonutilities averaged standard deviations of 10%, reflecting far more volatility.

3) Fewer negative returns. Utility stocks were more likely than other stocks to post positive 12-month returns. On average, the index's utilities posted positive returns in 87% of rolling 12-month periods over the last five years, versus 73% for nonutilities.

4) Strong returns. Don't fall prey to the common belief that utilities always lag other stocks over long periods. Sure, not all of them will shine, and as a group they lack the upside potential of many other sectors. However, S&P 1500 Utilities averaged annualized returns of 12% over the last three years, versus 11% for the index's other stocks. Over the last 10 years, utilities' compound annual returns of 11% topped the 9% delivered by nonutilities.

5) Diversification. Utilities tend to follow a different path than other sectors. In each of the last 12 calendar years and 18 of the last 20, the S&P 1500 Utility Sector Index posted total returns among either the top three or bottom three of the index's ten sectors. As a group, utility stocks rarely provide average returns, often excelling when cyclical sectors (such as technology, materials, and industrials) are at their worst. The utility sector index's correlation with the broad index is 0.49, lowest among the 10 sectors and well below the average of 0.75 for all sectors. A 1.0 correlation means two groups move in lockstep, while a 0.0 correlation assumes no connection between the groups' returns.

6) Valuation. On average, utilities trade at 18 times trailing earnings, 1.8 times trailing sales, and 1.8 times book value. Based on all three of these commonly used valuation ratios, utilities sport a discount of at least 15% to stocks in the rest of the index. In addition, utilities earn an average Quadrix Value score of 61, versus 56 for other stocks.

7) Top 15 Utilities. Utility stocks tend to share many characteristics, and differentiating between the investment appeal of individual equities is tougher in the utility sector than in most others. To combat that homogeneity, we created the Top 15 Utilities portfolio, which is just like it sounds, a selection of our favorite 15 selections. This portfolio has outperformed its benchmark by a wide margin since its inception at the start of 2007, as shown in the chart below. We advise readers who seek utility exposure to purchase equal-dollar amounts of all 15 stocks, rather than putting a larger amount in just one or two.

It's not hard to make a case for utilities, and some exposure to the sector makes sense for many investors. However, we'd advise most readers not to invest more than 20% of their portfolios in utilities, and few should go with a weighting of more than 10%. Here are seven reasons to exercise moderation with utilities — plus an eighth for good measure:

1) Operating momentum. The table above looks at sales and profit growth over the last one, three, and 10 years, plus estimated profit growth for the current year, next year, and over the next five. On average, utility stocks lagged the rest of the index for all nine of those growth metrics.

2) Dividend growth. While current yield matters, in our view dividend growth is just as important. We prefer companies that regularly boost their payout, growing investors' income over time. Utility stocks average lower dividend growth than the rest of the index, though they did boost the payout modestly, averaging an annual rate of 5% over the last five years.

3) Sector size. The S&P 1500 Index's total stock-market value tops $20 trillion. Utilities account for roughly $600 billion of that market value, less than 3%. While the Forecasts won't hesitate to overweight a sector if we can find an outsized number of strong stocks, the 10% cap we recommend is more than triple the market weight. Our Buy and Long-Term Buy lists have no utility exposure now. We don't mind eschewing entire sectors if we can find better opportunities elsewhere; our Buy and Long-Term Buy lists are fairly well diversified, despite their lack of utility stocks.

4) Regulatory oversight. Most utility companies generate the bulk of their revenue from regulated electricity, natural-gas, or water distribution. These regulated businesses must receive approval to raise rates, recoup capital spending, or boost the return on equity they are allowed to earn. This oversight both limits utilities' growth and subjects them to external forces they can't control.

5) Weather. While weather patterns affect many companies, few suffer the storms of repair costs and public opinion like utilities.

6) Valuation. This may sound like cheating because we cited valuation as a reason to buy utilities. However, while utilities do trade at a discount to other stocks, these valuations reflect their lower growth. In addition, many utility stocks look pricey relative to their own historical norms, not to mention their growth potential. Utilities average price/earnings-to-growth (PEG) ratios of 3.1, versus 1.6 for the rest of the index.

7) Small selection. The S&P 1500 Index contains 60 utility stocks, of which only four earn Quadrix Overall scores above 80. That's not a lot of high scorers, and not all of those high scorers look as good as the score suggests once we dig into them. The dearth of high scorers is a main reason we often have no utilities on our buy lists; we can usually find 15 utility stocks we like, but finding one we truly love is tough.

8) Quadrix. Utilities average Quadrix® Overall scores of 57, below the index average of 59. Just 7% of utility stocks score above 80 Overall, while 20% of the other stocks have reached such heights.

TOP 15 UTILITIES PORTFOLIO
12-Month
--- Growth ---
Company (Price; Ticker)
Div.
($)
Yield
(%)
Sales
(%)
EPS
(%)
Trailing
P/E
Ratio
Quadrix
Overall
Score
Industry
Allete ($51; ALE)
2.02
3.9
25
16
15
82
Electric
Atmos Energy ($63; ATO)
1.68
2.7
(16)
4
20
62
Natural gas
Avista ($35; AVA)
1.32
3.7
3
(8)
19
51
Diversified
CMS Energy ($36; CMS)
1.16
3.2
(6)
4
19
67
Diversified
EQT Midstream
($77; EQM)
2.56
3.3
42
53
16
85
Services
Laclede Group ($59; LG)
1.96
3.3
21
13
19
44
Natural gas
NextEra Energy
($104; NEE)
3.08
3.0
13
62
19
84
Electric
NiSource ($19; NI)
0.62
3.2
(4)
1
12
63
Natural gas
Portland General
($36; POR)
1.20
3.3
0
(9)
18
64
Electric
Public Service Ent.
($39; PEG)
1.56
4.0
5
49
13
94
Diversified
Scana ($61; SCG)
2.18
3.6
(4)
2
17
86
Diversified
Spectra Energy ($45; SEP)
2.45
5.4
11
(14)
14
93
Services
Star Gas Partners
($7; SGU)
0.38
5.1
(15)
79
15
87
Natural gas
Unitil ($36; UTL)
1.40
3.9
7
4
19
65
Diversified
WGL Holdings
($64; WGL)
1.85
2.9
(4)
30
20
42
Natural gas
Top 15 Utilities average
3.7
5
19
17
71
S&P 1500 utilities
average
3.5
(1)
2
18
57
Note: Quadrix scores are percentile ranks, with 100 the best.   NA Not available.

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