Seeking Alpha
Long/short equity, value, research analyst, deep value
Profile| Send Message|
( followers)  

We rec­om­mend investors avoid all util­ity sec­tor ETFs. We found no ETFs in the util­ity sec­tor that offer investors attrac­tive invest­ment merit and accept­able struc­tural integrity.

Per our first-quarter-2011 review of U.S. Equity Sec­tor ETFs, the util­ity sec­tor is one of five sec­tors that gets our “neu­tral” rat­ing. Fig­ure 2 shows how the util­ity sector’s stocks and the mar­ket value attrib­uted to them stack up under the micro­scope of our risk/reward rat­ing sys­tem. Only two com­pa­nies in this sec­tor get our “attrac­tive” rat­ing while five are ranked “very dangerous.”

[Click all to enlarge]

Fig­ure 1: Util­ity Sec­tor – Cap­i­tal Allo­ca­tion & Hold­ings by Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

The util­ity sec­tor has 38% of its value invested in dangerous-or-worse-rated stocks and only 4% of its value invested in attractive-or-better-rated stocks. Rel­a­tively high allo­ca­tion to dangerous-or-worse-rated stocks causes the util­ity sec­tor to earn our neu­tral over­all risk/reward rating.

The key take­away is that the util­ity sec­tor offers very few good invest­ment oppor­tu­ni­ties because there are so few attractive-or-better-rated stocks in the sec­tor. The invest­ment value of each ETF is derived from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks are great invest­ment oppor­tu­ni­ties while ETFs that over­weight neutral-or-worse-rated stocks should be avoided.

When ana­lyz­ing the util­ity sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the five ETFs whose XTF rat­ing was above the sec­tor aver­age XTF rating.

Fig­ure 2: Util­ity ETFs With Accept­able Struc­tural Integrity

Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all util­ity ETFs are made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently.

After deter­min­ing the struc­tural integrity, we ana­lyzed the invest­ment merit of each ETF based on how it allocated value to each stock it held. Fig­ure 3 shows how the five util­ity sec­tor ETFs stack up ver­sus each other and the over­all sec­tor based on their over­all risk/reward rat­ings and the allo­ca­tion of their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

Sources: New Con­structs, LLC; XTF and com­pany filings

Attrac­tive ETFs:

We find no attractive-or-better-rated util­i­ties ETFs.

Neu­tral ETFs:

Three util­i­ties ETFs allo­cate the value of the fund in a way that earns them a Neu­tral Over­all Risk/Reward rat­ing: XLU, IDU, and VPU. We rec­om­mend investors buy the Very Attrac­tive and Attrac­tive stocks in this sec­tor before buy­ing any of the util­i­ties ETFs we cover in this report.

Dan­ger­ous ETFs:

We rec­om­mend investors avoid or sell short UTH and RYU because of their dangerous-or-worse over­all Risk/Reward rat­ings. Fig­ure 3 con­trasts the dif­fer­ence in invest­ment merit between XLU, RYU, and the over­all sector.

Bench­mark Comparisons Sec­tor Benchmark

XLU has sim­i­lar rat­ings to the over­all util­i­ties sec­tor. XLU has a market-implied Growth Appre­ci­a­tion Period (GAP) of seven years com­pared to the over­all sector’s GAP of 11 years. XLU’s shorter GAP makes it a more attrac­tive invest­ment than the over­all sector.

Fig­ure 4: XLU – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Util­i­ties Sec­tor – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

XLU more effec­tively allo­cates cap­i­tal than the over­all util­i­ties sec­tor. Per Fig­ure 3 above, XLU allo­cates only 4.1% of its value to attractive-or-better-rated stocks while the sec­tor allo­cates only 3.8%. XLU also allo­cates 31% of its value toward dangerous-or-worse-rated stocks com­pared to the sector’s dangerous-or-worse weight­ings of 37%.

Mar­ket Benchmark

The S&P 500 out­per­forms XLU in qual­ity of earn­ings rat­ings. XLU earns a Neu­tral Eco­nomic vs. Reported Earn­ings rat­ing while the S&P 500 earns a Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ing because its Eco­nomic Earn­ings are pos­i­tive and rising.

XLU out­per­forms the S&P 500 in val­u­a­tion rat­ings. XLU has a Price-to-EBV of 1.1, earn­ing it a Very Attrac­tive rat­ing, and a GAP of 7 years com­pared to the S&P 500’s Price-to-EBV of 1.5 and GAP of 24 years.

Fig­ure 6: XLU – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 7: S&P 500 – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

The S&P 500 more effec­tively allo­cates cap­i­tal than XLU. Per Fig­ure 3 above, XLU allo­cates 4.1% of its value to attractive-or-better-rated stocks while the S&P 500 allo­cates 41.3%. XLU also allo­cates 31% of its value toward dangerous-or-worse-rated stocks com­pared to the S&P 500’s dangerous-or-worse weight­ings of 23.8%.

Method­ol­ogy

This report offers rec­om­men­da­tions on util­ity sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buying util­ity sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the util­ity sec­tor and the S&P 500. Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (89 com­pa­nies) based on data as of April 4. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks.

To make an informed ETF invest­ment, investors must consider:

1) The struc­tural integrity of the ETF and its abil­ity to ful­fill its stated objec­tive. We use XTF to find the top five ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine and ETF’s qual­ity using our over­all risk/reward rat­ing system.

Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions. Barron’s reg­u­larly fea­tures our unique ETF research.

Source: Bad and Ugly Utility Sector ETFs