Utilities: Great Danger Ahead - Bezek's Daily Briefing

| About: Utilities Select (XLU)

Summary

Utilities are quickly turning into another example of irrational yield-chasing.

At current prices, new buyers are locking in mediocre or worse returns.

If you want to speculate on interest rates continuing to drop, buy bonds. Utilities add risk and complexity without much additional yield or growth prospects at current prices.

Stocks recovered from yesterday's Europe-induced slump. After starting off well in the red, US markets rallied and closed up about 0.5% across the board. Today's Briefing will focus exclusively on the utility sector, since there's little in today's market grabbing my interest.

Utilities Priced For Mediocre Returns

Utility stocks (NYSEARCA:XLU) have been on a breathtaking run. As an industry, they're up almost 30% since late last fall. It's been a stunning run:

XLU Chart

XLU data by YCharts

Utilities are not the sort of industry that you generally count for rapid appreciation. With earnings growth rates typically below 5%, a 30% capital gain can represent the better part of a decade's worth of potential return. Due to the surge in bonds, utility investors have "pulled forward" many years of gains into one huge surge throughout early 2016.

Between 2001 and 2015, as a reminder, utilities returned only 25% in capital gains. Put another way, utilities have shown more upside since last fall than they had in the previous 14 years total. Utilities' overall return, as it usually does, came more from dividends than the utility stocks' share price gains. Thus, your starting yield is of the utmost importance.

Overall, over that 14-year span ending last July, a $10,000 investment in the XLU utility ETF turned into just $22,487, a less than 6% annual return. This includes dividends, without them the return would have been much less.

Over that same span, which included the greatest financial crisis of our investing lifetimes, utilities underperformed the S&P 500. Turns out, utilities aren't even that great at shielding investors from a market panic:

XLU Chart

XLU data by YCharts

As you can see, utilities lost half their value peak to trough in the financial panic, a figure not meaningfully different from the S&P 500. And in return for the perceived safety of utilities you gave up a great deal of the recovery; the sector wouldn't recover to its 2008 levels until mid-2014.

Utilities, due to their very nature, can't achieve large growth rates in the vast majority of cases. And due to that, dividends can't rise that quickly either, since dividend hikes are rooted in earnings growth.

Between 2001 and 2015, XLU's dividend rose from $0.88 to $1.59, which is less than a double over 14 years. Stated otherwise, utilities raise their dividends at well under 5% annually on average. Extrapolated forward, utilities purchased today won't yield 6% on cost until sometime in the early 2030s. That's not so good.

I understand the appeal of utilities as a source of seemingly low-risk stable yield. However if you pay an egregious price - such as the levels where utilities are trading now - you are taking a great risk.

That is simply that the market will reprice your investment back to normal valuation ratios, leaving you with a massive near-term capital loss. And since utilities hardly grow, sitting on your underwater stock for a few years still won't do much as far as letting it "grow into its valuation."

Consider the yields that utilities have traded at over the past 15 years:

XLU Dividend Yield (<a href=

XLU Dividend Yield (TTM) data by YCharts

Buying utilities at 3% yields has traditionally led to poor returns - as both buyers in the early 2000s and between 2005-07 learned. A return to a 4%-yielding XLU, a very plausible scenario, would leave shares at $40 wiping out all the gains over the past year. A return to 5% utility yields, a level they've often traded at in past decades, would drop XLU stock to $32 - a big blow from the current $53 price.

At this point, it's hard to be much more bullish on utilities compared with the simple alternative of buying a bond yielding 3% outright. At least the bond gets paid off in full at maturity instead of utilities which are likely to see substantial capital losses, if yields head anywhere back toward more normal levels.

Yes, there could be a "greater fool" trade here in the sense that if US rates keep plunging and eventually end up negative, utilities would likely keep rising even further. But if you want to bet on that, simply buy bonds - it's the same trade and bonds are an easier way to express that speculative intent.

Utilities, as represented by XLU, saw their dividends paid out drop in 2001, 2003, 2007 and 2010. The dividends are generally safe, but they can and are in fact cut from time to time during periods of economic stress or specifically-troubling times in the energy business.

Buying utilities at today's levels, you're taking on a significant amount of executional business risk in return for an almost guaranteed paltry longer-term return. The growth rates are simply too slow to dig yourself out of the hole that comes from buying this sort of stock at P/E ratios above 20.

Don't fool yourself, utilities here have essentially the same potential upside as bonds with significantly bigger potential downside. Don't forget, utilities dropped 50% in 2008. Most high-quality bonds didn't come close to that magnitude of loss.

Utilities have gotten popular now since everyone wants perceived safety without giving up yield. Like other recent examples of mass yield-chasing such as the MLPs in 2014, this too will probably end badly. Utilities are defensive stocks, as such they should be bought when everyone else is focused elsewhere. Generally, by the time CNBC is talking about playing defense, it's too late to get popular defensive stocks such as utilities at acceptable prices.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.