Utilities Operating In Low Gear
If you judge by stock returns, utilities look like the hottest sector.
The average utility in the S&P 1500 Index has returned 21% this year (first among sectors), 26% over the last 12 months (first), and 17% annually over the last three years (second).
Utilities also average the highest dividend yields, a hugely popular feature. High yields and strong recent returns make for a heady brew, but shrewd investors take a broader view.
A utility shareholder owns a stake in an operating company. Just like industrial or technology companies, dividends and share-price gains ultimately hinge on profits and cash flow. As such, we prefer to analyze them like operating companies, considering their growth, valuation, and fundamental strength.
• On average, utility stocks saw per-share profits fall 2% over the last year and are expected to grow profits 6% over the next 12 months, both in the bottom half among sectors.
• Despite their subpar growth potential, utility stocks aren't especially cheap, averaging trailing P/E ratios of 21, roughly in line with the index average and near a record high. Since 1994, utilities have averaged cheaper valuations than the average stock, reflecting their market-lagging growth.
• Utilities average Quadrix Overall scores of 45, second-worst among the 10 sectors. Among the 75 stocks in our Utility Update, only one scores above 80 Overall and just two top 70.
When picking utility stocks, we look for the same characteristics we seek in stocks from other sectors:
• Strong Quadrix scores.
• Superior operating momentum.
• Attractive valuation ratios, such as price/earnings and price/book ratios.
In a perfect world, we'd prefer utilities that look good from all three of the above angles, but few (if any) qualify, which explains in part why none make our buy lists at this time. A utility rarely ranks among our favorite 25 to 30 stocks.
All that said, while utilities are indeed operating companies, they have other characteristics all their own. As regulated businesses, and often monopolies, utility stocks' results can hinge on government decisions about rate hikes and recovery of capital expenditures. In addition, weather affects utilities more than it does most other stocks.
Because of their yields, and because of the perceived safety of their businesses, risk-averse, income-hungry investors particularly like utilities.
Otter Tail ($33; OTTR) supplies electricity to more than 130,000 customers in Minnesota and the Dakotas and also operates a series of industrial businesses — metal fabrication, plastics, and PVC pipe. The nonregulated operations have had a rough go of it in recent quarters, but Otter Tail is better positioned than most to benefit from improving economic conditions. Profit margins have marched higher over the last two years, yet profit-growth expectations remain low enough to leave room for surprises. Otter Tail, which scores above 75 in both of our sector-specific scores, is being added to the Top 15 Utilities portfolio.
Spire's ($68; SR) Quadrix Overall score has fallen to 29, dragged down by weak operating results and an unattractive valuation. Yet despite the company's erosion of growth and two consecutive quarters of weaker-than-expected profits, the shares are flirting with a new all-time high. From these levels, we see plenty of downside risk. Subscribers should sell Spire.
Investors who seek utility exposure should consider our Top 15 Utilities portfolio (www.DowTheory.com/Go/Top15). We designed the portfolio to provide diversified exposure to the utility sector, generating a yield comparable to the typical utility but with greater capital-gains potential.
To meet our goals with the portfolio, we have historically sought energy exposure in one of two ways:
• Utility/energy hybrids that operate both regulated utilities and energy-production businesses.
• Master limited partnerships that distribute propane or transport and store oil and natural gas. At the moment, the Top 15 Utilities portfolio features three such MLPs.
If you wish to track the Top 15, purchase equal-dollar amounts of all 15 stocks listed in the table below. Since its inception in 2007, our portfolio has returned 191.0%, including dividends and excluding trading costs, versus 106.9% for the S&P 1500 Utility Sector Index, topping the benchmark in seven of the nine calendar years.
Despite our portfolio's historical outperformance of the sector — and the sector's outperformance of the rest of the market — investors shouldn't put too many eggs in the utility basket. Holding more than 20% of an equity portfolio in utilities is a big bet on a small group with relatively few top-ranked stocks. For context, utilities account for 3.6% of the S&P 1500 Index's market value.