After The U.S. Utilities Rally, And A New View Of India

Includes: HDV, INDY, IXP
by: Russ Koesterich, CFA

Call #1: Underweight U.S. Utilities Sector

The U.S. utilities sector was a top performer in 2011, gaining roughly 15% compared with a flat performance for the broader market.

In retrospect, it’s not hard to see why. Utilities have two characteristics that were in demand last year: Safety and yield. However, last year’s rally has now left the sector very expensive compared with its history and the broader market.

As of the end of December, U.S. utilities were trading at more than 13x trailing earnings, a 7% premium to the broader market. Because the utility business is a regulated, slow growth industry, utility stocks have historically traded at a 25% discount to the broader market. Even in the past four years, when investors have generally favored utilities as a safe-haven play, the sector has still traded at about a 15% discount to the overall stock market.

It’s certainly true that utility stocks tend to do better in a relative sense when the economy is weak. But given the recent stabilization in the U.S. economy, the current premium looks very hard to justify. Even when I account for relatively weak economic expansion, utility stocks still look around 20% overvalued relative to the broader U.S. market.

In addition, if the current preferential tax treatment of dividends expires as expected in 2013, multiples may compress in the sector. As such, I’m now advocating underweighting U.S. utility stocks within an equity portfolio.

For those investors still focused on income, I would instead suggest focusing on a broad yield play such as the iShares High Dividend Equity Fund (NYSEARCA:HDV) and on global telecoms, which can be accessed through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA:IXP).

For those investors who are also looking for the relative safety of utility stocks, I’m still maintaining my neutral (or benchmark) view of the global utilities sector in general, and I’m now advocating getting that exposure through a position in international utilities.

Call #2: Neutral India

I first advocated an underweight to Indian equities last April. At that time, the Indian stock market looked expensive relative to other developed markets, and I expected the Indian economy to contend with high inflation throughout most of 2011.

Since then, Indian stocks have fallen approximately 30% and are trailing a broader emerging markets index by 10%. Now, Indian stocks appear more reasonably priced. Large-cap Indian equities are trading at 12x next year’s earnings and at around 2x book value.

In addition, while inflation has remained stubbornly high in India, I expect some of that pressure to ease this year. In particular, I expect to see an easing of food inflation, which makes up roughly 50% of the Indian inflation index. This should benefit Indian equity valuations.

For these reasons, I’m upgrading my view of India to neutral. I’m advocating an allocation to Indian stocks equivalent to their weight in the broader MSCI emerging markets index. A potential iShares solution is the iShares S&P India Nifty 50 Index Fund (NASDAQ:INDY).

Disclosure: Author is long IXP.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility. There is no guarantee that dividends will be paid. Past performance does not guarantee future results.

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