Utility Sector: Check The Ingredients Before Buying

 |  Includes: FUI, FXU, IDU, PSCU, PUI, RYU, UPW, VPU, XLU
by: David Trainer

High div­i­dend yields are not enough to war­rant invest­ing in the util­i­ties sector.

Too many investors put their hard-earned money in util­ity stocks with the assump­tion that rel­a­tively high-yielding div­i­dends from sta­ble busi­ness make a good investment.

The real ques­tion that investors in any equity secu­rity must ask is: does my expected return from a stock jus­tify the risk of invest­ing in it?

The answer for the utility sector is “no” except for 2 stocks or 4% of the market value of the sector: DPL Inc. (DPL – attractive rating) and Public Service Enterprise Group (PEG – attractive rating). Well, actually one stock because DPL recently agreed to be taken over by AES Corp (AES - neutral rating). AES was smart to buy DPL on the cheap, and the market rewarded AES accordingly as it sent its stock up over 5% upon consummation of the takeover agreement. There are no other attractive-or-better-rated stocks or ETFs in this sector, which means investors should avoid or sell everything in the sector except for PEG.

Nev­er­the­less, there are at least nine util­ity sec­tor ETFs. These nine ETFs have dras­ti­cally dif­fer­ent stock hold­ings and, there­fore, allo­ca­tions. The low­est num­ber of hold­ings is 22 while the high­est is 85, per fig­ure 1.

Fig­ure 1: Hold­ings Count of Util­ity Sec­tor ETFs

(Click to enlarge)
Sources: New Con­structs, LLC and ETFdb. * # of Hold­ings excludes cash

The take­away from the fig­ure above is that investors can­not trust the labels that Wall Street puts on invest­ments any more that you can trust the ingre­di­ents in pack­aged foods. Smart invest­ing requires know­ing the ingre­di­ents of what you are buy­ing just as healthy eat­ing requires know­ing what is in the food you eat.

I stud­ied the ingre­di­ents of the util­ity sec­tor from the ground up, which means I stud­ied the foot­notes for each com­pany within the sec­tor and built a model for each com­pany. Then, I aggre­gated all of the com­pany mod­els to assess the over­all sec­tor and how it com­pares to the other nine sec­tors of the econ­omy and the S&P 500.

The results of this work do not paint a pretty pic­ture for the util­ity sec­tor because they reveal that the expected returns of invest­ing in util­ity stocks do not com­pare well to the risks.

Investors should take note that a good div­i­dend yield is not enough to jus­tify an equity invest­ment because dividends do not accu­rately rep­re­sent the true cash flows of the busi­ness. In other words, div­i­dends are a use of cor­po­rate cash and can come from cash reserves, bor­row­ings or the oper­a­tions of the busi­ness. Free cash flow, on the other hand, takes into account div­i­dends as well as all other cap­i­tal expen­di­tures. It is the num­ber by which one can mea­sure the finan­cial health of a busi­ness over time.

Even if the div­i­dend yield by itself is higher than an investor’s required rate of return, the investor can­not trust that the div­i­dend is sus­tain­able. Quite often, a high div­i­dend yield is a func­tion of a depressed stock price rather than a high div­i­dend pay­ment. And the depressed stock price may be sig­nal­ing that the future cash flows of the busi­ness are in for a decline that could force a div­i­dend cut.

When I assess the invest­ment merit of the util­i­ties sec­tor, I focus on cash flows and how much future cash flows are required to jus­tify the stock price of every stock in the sec­tor. This approach is the only truly com­plete approach to fun­da­men­tal analy­sis of equity securities.

As men­tioned above, the results of my analy­sis are not very pos­i­tive for the util­ity sector.

Fig­ure 2 shows how the mar­ket value of the stocks is divided accord­ing to New Con­structs rat­ing sys­tem. All but 4% of the mar­ket value of the sec­tor is in neutral-or-worse stocks. The only two attractive-rated stocks, PEG and DPL, make up only 4% of the mar­ket cap of the sector.

Fig­ure 2: Util­i­ties Sec­tor – Allo­ca­tion & Hold­ings by Pre­dic­tive Rating

(Click to enlarge)
Sources: New Con­structs, LLC and com­pany filings

The util­ity sec­tor gets my “dan­ger­ous” rat­ing and ranks eighth out of the ten sec­tors that make up the econ­omy. Details are in our sec­tor roadmap report.

Fig­ure 3 shows how the ETFs for the util­ity sec­tor stack up under the micro­scope of my analy­sis. There is not a sin­gle util­ity sec­tor ETF that gets an attractive-or-better rat­ing or that ranks bet­ter than the S&P. Investors are bet­ter off87 in the more-diversified S&P 500 (i.e. SPY) than any util­ity ETFs.

After review­ing Fig­ure 2, I am not sur­prised by Fig­ure 3. If there is lit­tle mar­ket value allo­cated to attractive-or-better-rated stocks, then there are sim­ply not a lot of good invest­ment oppor­tu­ni­ties within the sec­tor. For a util­ity sec­tor ETF to get an attrac­tive rat­ing, it would have to allo­cate a major­ity of its value to the two stocks (DPL and PEG) which make up only 4% of the value of the sec­tor while avoid­ing the 56 stocks that get a dangerous-or-worse rat­ing and make up 47% of the sector.

Such a con­cen­trated invest­ment in two stocks defeats the value of hav­ing an ETF. But you can­not trust ETF issuers to tell you that. No, instead, they will serve you up nine very tasty look­ing util­ity sec­tor ETFs. Buyer beware.

Fig­ure 3: Invest­ment Merit of Allocations

(Click to enlarge)
Sources: New Con­structs, LLC and com­pany filings

The take­aways for investors are:

  1. Don’t trust the labels that issuers put on ETFs, stocks or any invest­ment vehicle.
  2. Make sure you know exactly what you are buy­ing (check the ingredients)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.