Utilities: The Forgotten Sector

Includes: FXU, GLU, IDU, IPU, JXI, RYU
by: Thomas MacLeod

There has been relatively little discussion as of late on utility stocks. They appear to be the forgotten sector with comparably more attention given to the “USD hedge” sectors such as energy, materials and emerging markets.

However, we would like to draw your attention to the utility sector because of the attractive fundamental valuations and the “constructive” behaviour of many utility stock prices.

Apart from the rather dramatic sell-off in March utility stocks have generally had constructive price patterns and showed a general reluctance to participate in the weakness in the Dow in June and early July, which suggests that a significant bottom has probably already been found.

If we look at the performance of utility stocks on an equally weighted basis (as per the Rydex equally weighted utility index) the price patterns look even more attractive.

From a valuation perspective the median price/book ratio of the top 20 utility stocks in the US is 1.5x and the median ROE is 13%.

To support this p/b ratio a long term growth rate of 3% is implied. Is that reasonable?

If a ROE of 13% can be maintained then the growth rate should be more like 5.5%. At a 5.5% growth rate (assuming an 8.5% cost of equity and 55% payout ratio) the P/B ratio should be 2.5x (which has more or less been the long run p/b ratio for utilities).

And with a median dividend yield of 5% we think that it is a no brainer on whether or not to invest in utility stocks or US 30 yr treasuries (at 4.3%) for the long term.

Either which way we approach the valuation equation it appears that at 1.5x p/b and a dividend yield of 5% US utilities are substantially undervalued.

Disclosure: Long RYU