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The Speculative Look of Utility Stocks

The Speculative Look of Utility Stocks
Utility towers in Underwood, North Dakota. Photographer: Daniel Acker/Bloomberg

Spurned by the Federal Reserve’s interest rate policy that has pushed the 10-year Treasury note yield below 2 percent, income seekers are enjoying a rebound relationship with utility stocks flashing come-hither 4 percent or so average yields.

Mutual fund and exchange-traded fund assets in the utility sector increased more than 30 percent in the 12 months through July, according to Morningstar. Not only did investors pocket a bond-beating yield, the sector’s total return for the year (yield plus capital gains on the underlying stocks) was nearly 20 percent for the classic defensive group. It all sounds so promising. Yet investment pros warn the lovefest with utility stocks could be headed for rocky times.

Value disconnect

For the most part, the argument against utilities isn't based on their balance sheets. It's tied to the runup in the price of their stocks. The slow-growth utilities sector typically trades at a valuation 20 percent or so below the level of the overall S&P 500. The price/earnings ratio of the Bloomberg Industries index tracking North American regulated integrated utilities is 14.9, based on estimated earnings for the next 12 months. That leaves a 16.3 percent gap between it and the 12.8 p-e estimate for the S&P 500 over the same period.

“I don’t remember a time where there was this speculative element to utilities,” says Brad Sorensen, director of market and sector analysis at the Schwab Center for Financial Research. Despite the high valuation, Schwab has a “market perform” rating for the sector for the next three to six months. It's based on the expectation that continued macro issues -- slow growth and the looming fiscal-cliff issues in the U.S., and the continued wait for resolution of the European sovereign debt crisis -- will buoy the defensive sector.

Russ Koesterich, global chief investment strategist for iShares’ ETF business, recently took to the blogosphere with a warning: “The [price-earnings] premium can’t be justified by U.S. utilities being more profitable than in the past. In fact, the U.S. utilities industry is currently less profitable than its long-term average. Return on earnings for U.S. large-cap utility companies is currently 10.5 percent, the lowest level since 2004.” At the same time, managers such as Roger Conrad, editor of the Utility Forecaster investment newsletter, say the companies are in good financial shape: “This is not like 2000," says Conrad, "when utilities were branching into new business lines and ended up getting into a lot of trouble. The industry as a whole is being run very conservatively now.”

That may be so, but from today’s lofty valuations, the sector is set up for a harder fall when the economic storm clouds dissipate and defensive sectors become less attractive. Just take a look at what happened last January when the economic zeitgeist was rosier. The $6 billion SPDR Utilities Sector ETF lost 3.6 percent, while the S&P 500 stock index gained nearly 4.5 percent.

Premium Pricing

The trick for investors who want to be in utilities now, says Conrad, is to avoid paying too much for the attractive yields. Regulated utilities, the least economically sensitive segment of the sector -- rates are set by regulators, not market supply and demand -- are where the most danger lurks. Ever since the financial crisis, this recession-resistant segment of the market has been the most popular among investors looking to play defense and collect a bond-beating yield.

For example, Conrad says the Southern Company (4.3 percent yield) is a well-run utility in a solid (Southeast) market. A price-earnings ratio near 19, compared with 13 for the S&P 500, makes it less compelling for investors with fresh cash to put to work than an unregulated utility such as Entergy (4.8 percent yield) that trades at a current p-e of 9.7 percent. Southern makes up more than 7 percent of the $691 million iShares Dow Jones Utility ETF.

Maura Shaughnessy, a manager with the $4.5 billion MFS Utilities fund for 20 years, is cherry-picking unregulated U.S. utilities. Since energy delivery in the U.S. is highly regional -- there’s no national power grid -- she likes both Calpine and NRG Energy, given their roots in Texas. There is strong energy demand in the state, and less supply, due in part to coal plant shutdowns. Shaughnessy is also finding value in European utilities such as Energias de Portugal (9 percent yield, 6.7 p-e). “The macro [economic picture] in Europe is whipping everybody right now,” says Shaughnessy, “but if you are patient, these are lifetime values I’ve never seen in Europe.”

Another option is to set your sites on other sectors that offer a compelling yield story without frothy valuation. Sorensen of Schwab recommends taking a look at health care, where yields of 3 percent or so can be found with better valuations. According to data provider S&P Capital IQ, the health sector’s price-earnings growth, or PEG, ratio is 1.3, compared with 3.2 for the utility sector. That’s a powerful argument for broadening a yield-seeking portfolio beyond the much-loved utility sector.

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