PowerShares Utilities Sector ETF: Safe for This Volatile Market

 |  Includes: AEP, D, DUK, EXC, FE, FPL-OLD, NRG, PEG, SO
by: Don Dion

The utilities sector, considered to be one of the most defensive corners of the market, steered through this month’s tumultuous stock market relatively steadily. Among the 12 sectors Morningstar tracks, utilities’ 3.43% gain came out on top for the one-month period ending November 27. Health care was the only other sector to gain ground for the period.

Utilities stocks rarely move in step with broader market indices, making them appealing when the outlook for the overall economy appears bleak and a significant market correction seems due. With record-high energy prices and the extent of the fallout from the credit-market and financial sector troubles still unclear, bearish investors looking for a safe haven are keeping utilities stocks afloat even as the rest of the market sinks. If the economy worsens, utilities funds such as PowerShares FTSE RAFI Utilities Sector Portfolio (PRFU) may become even more popular—but if optimism wins out, PRFU may be overshadowed by funds with higher return potential.

PRFU’s portfolio usually comprises about 70 stocks in U.S. companies that provide water and energy. Like all PowerShares FTSE RAFI funds, PRFU is not market-weighted; rather, its holdings are selected through a formula that considers book value, sales, cash flow and dividends. That approach helps prevent the fund from overloading on stocks with soaring valuations, potentially heightening its ability to withstand a market downturn. The fund’s average market capitalization recently hovered around $12.4 billion.

Utilities stocks aren’t known for delivering the kinds of returns we’ve seen from energy and materials stocks in recent years, but they have their own charms. For one, people always need water and electricity, regardless of the state of the economy. That fact means recessions have minimal effect on the companies’ bottom lines. Utilities stocks also tend to pay higher dividends than do most stocks—in part because regulations crimp the firms’ growth prospects, so there’s little incentive for utilities companies to reinvest profits. High dividend payouts make utilities stocks especially attractive when bond yields decrease, as has occurred since the Fed’s recent rate cuts.

Still, utilities companies face no shortage of challenges. Most of the companies in which PRFU owns stock are focused on particular regions of the U.S. and are highly influenced by local regulations. Currently, one of the hottest regulatory issues affecting utilities firms is new carbon-emissions laws, which are forcing companies to make substantial capital investments to reduce their carbon footprints. Government mandates aren’t the only reason for electric utilities to invest in energy efficiency: Producing energy usually requires oil, coal or natural gas, and prices for those commodities are soaring. Yet another challenge affecting the electric utilities industry is the urgent need to upgrade the nation’s deteriorating transmission grid and increase production capacity.

The need for cheaper, cleaner and more abundant electricity is spurring many utilities companies to explore renewable energy projects and nuclear energy production. Many utilities companies can be expected to divert a substantial amount of their capital to these projects in the coming years, with uncertain consequences for their stocks.

A large portion of PRFU’s assets—recently more than 45%—typically reside in its top ten holdings, which generally see very little turnover. Top holding Reliant Energy (RRI), which accounted for 12.28% of PRFU’s assets as of late November, has been one of the top-performing utilities stocks this year. Its more than 80% year-to-date gain through November 23 played a large role in boosting PRFU’s returns in recent months. Reliant, which distributes electricity to 1.9 million residential and commercial customers in Texas, has attracted investors’ attention with its impressive capacity to generate electricity during a time when demand is high.

Number two holding Exelon (NYSE:EXC), the largest nuclear-plant operator in the U.S., also served the fund well recently. It gained 32.63% year to date on the back of increasing energy costs and interest in carbon-free energy sources. Exelon generates power at a cost of around $15 per megawatt hour, in a market in which power sells for $60 to $80 per megawatt hour—helping the firm generate a comfortable profit margin.

PRFU shot up to 17 on the Sector Momentum Table last week, from 30 only a month earlier. The fund’s year-to-date gain of 9.6% on November 23 was nearly nine percentage points ahead of the S&P 500’s barely positive return. With the economy appearing to turn sour, now could be a wise time to take a small stake in the utilities sector. But while utilities stocks can be counted on to provide a flow of income—just as they provide reliable flows of electricity and water—investors shouldn’t expect them to generate lights-out returns.