I'm Avoiding These Two Stock Sectors

 |  Includes: FXU, SO, VZ, XTL
by: Income Surfer


Utility and Telecom stocks tend to offer higher dividend yields than the average S&P 500 company.

Low interest rates have forced income investors to seek yield outside of bonds and CDs.

I believe Utility and Telecom stocks are now riskier than investors realize.

Regular readers of my free email newsletter and blog know that I don't shy away from talking about which companies and sectors I feel represent a good value. I am even more vocal when it comes to which companies and sectors I see as the most overvalued. In the past 6 months I have taken some heat for voicing my concerns about the US Telecom and Consumer Staples sectors. With many dividend growth portfolios dedicated to those sectors, my fellow dividend growth investors were not very happy to read my thoughts on thoughts on those popular holdings. Since that time, the valuations of many consumer staples companies have stabilized. While still elevated, I don't consider them nearly as overpriced as they once were. Instead, I'm going to add another sector of concern... domestic electric utilities.

First up is the US Telecom space. In the linked article I give my reasons for why the future isn't as bright as the past for US legacy carriers like AT&T (NYSE:T) and Verizon (NYSE:VZ). In a few years their star will shine again, but not before significant consolidation within the sector restores some semblance of pricing power. Several companies in this industry are currently involved in a price war, which is great for the consumer but will almost certainly reduce future profit margins for the companies. So while I believe the consumer will benefit, shareholders will likely lose.

On a practical level, I know my phone and internet cost dramatically less per month today than they did 2 years or 5 years ago. Furthermore, I know that I have better quality (and more powerful) service now. Some readers will be quick to point out that the stock price of Verizon and AT&T is each 10% higher than when I wrote the story. I accept that, and will be willing to concede my argument is flawed if their price remains elevated in 2 or 3 years... but within any equity market a few months matter not. I'm a trader, not an investor. Just think about the intermediate term implications of the advertisements (hawking cheaper voice and data plans) that show up in your mailbox every other day. These two industry stalwarts will still be around in 5 years, but I contend they will have more debt and decreased margins.

Now, on to Electric Utilities. I consider most US based electric utility companies to be vastly overpriced. While there are exceptions, like Consolidated Edison (NYSE:ED) and Entergy (NYSE:ETR), the majority of the companies in this sector trade with at price to earnings multiples that should rival growth companies. Instead, you have a mature (and very slow growing) company. I recognize growth isn't everything and many of the electric utilities provide solid dividends, but I believe that what you pay for a company truly does matter. See the valuation table below, of data provided by Morningstar.com.

Many critics have complained that the easy money policy and low interest rates set by the US Federal Reserve have inflated a bubble in the global stock markets. I don't know if that's true, but I am fairly certain that those policies have forced many income investors (think retirees and insurance companies) to invest in a group of dividend paying stocks that I refer to as "bond proxies". The companies in this group are all "stable" blue chip companies, many with long histories of paying dividends. These income investors are purchasing these dividend companies out of necessity, because they require higher yields than US government treasuries are offering. Instead of purchasing a 10 year US government bond that is yielding 2.5%, they invest in a company like Southern Co (NYSE:SO) and receive a 4.8% dividend. The problem is that these companies are not bonds and there are several ways I see these investments going wrong. In addition to company specific risk, they are also heavily exposed to interest rate risk. Most likely, these investors will sell their utility investments if/when the yield on US government bonds climb back to a reasonable 4%-6%. Additionally, these investors may be scared out of their positions if we experience a significant stock market sell off. Bonds can certainly go down in price, in fact I believe credit to be the most overpriced asset currently, but with a bond you have the option of holding the security until maturity... and receiving your predetermined interest payments along the way and your principle. Not so with an equity investment. There is also the issue of security, in the case of bankruptcies and defaults, where bondholders are given preferential treatment.

I call this trade "yield at any price", and consider it fairly crowded. In the last couple months the utility sector has finally started to under perform the broad S&P 500, as you can see from the CNNMoney chart above. I think that either of the scenarios I've laid out above will result in the utility and telecom sectors grossly underperforming the S&P 500. In years past these sectors were considered defensive, but I believe that dynamic has changed as a result of the Federal Reserve's interest rate policy. Worse yet, I believe once these sectors start to slide, their decline will reinforce itself. After all, plenty of investors are in the sector for the combination of yield and price stability. What will happen when these companies loose either of these competitive advantages? For my money, there are better opportunities elsewhere.


I do not own any of the stocks mentioned in this article. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by Yahoo Finance, Morningstar.com and Money.cnn.com.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.