In my series of building a model portfolio sector by sector, in which the final sector was utilities, I realized that there was little value to be found in electric utilities. I suggested that these stocks are best purchased on pullbacks and the sector should be under-weighted. Over the last few weeks a further analysis was undertaken to determine the investment merits of the sector. As readers might know, I analyze equities by using a combination of valuation (both absolute and relative), fundamentals, and technical analysis.
To begin the analysis, five electric utilities were selected to represent the sector. An equal weighted group comprised of Southern Company (SO), Dominion (D), Consolidated Edison (ED), Duke Power (DUK), and Scana (SCG) formed the index. The necessary data was downloaded to an Excel spreadsheet from which the following charts were built to analyze the sectors. The first chart compares the PE of each stock to the PE of the S&P 500 since 1986. Each stock in our study is at the highest level over the 25-year period examined. I do not view this level of valuation to the market to be a opportunity to initiate positions.
A chart of the index is shown below. The results are of course identical, but perhaps easier to view. The utility index is 3 times as expensive currently as it was in 1986 and 2000.
The following example charts the relative yield of each utility stock to the S&P 500. As with the relative PE, this charts demostrates that the utility stocks are over valued on a yield basis also.
As with the relative PE, the chart below shows the index relative yield to the S&P 500, The poor valuation does not favor an upcoming period of superior performance.
Just because a stock is at the low end of its valuation does not mean that the shares cannot trade higher. It does not mean that the shares will decline either. It simply means that better values are likely to exist elsewhere in the market place. In the current environment of a Federal Reserve policy to maintain a low level of interest rates means that utility shares should not be in danger of producing poor results. However, due to the poor valuation, when rates begin to rise, they will likely become sub par performers.
Technical View: Despite the fact that the utilities lack value, they do however, have good market momentum as many of them are at new highs. The chart below is the Dow Jones Utility Index that has the potential for a triple top at the 84 level. A breakout above that level would indicate a continuation of the upward trend.
Conclusion: Both the absolute and relative valuation of utility stocks point to poor valuation. However, in the current environment of low interest rates, the shares of most utilities should fair well enough to maintain current positions. I would not however, purchase additional shares as other dividend growth stocks off better value and potential at the current time.
Disclosure: I am long SO.