Utility sector ETFs have performed well this year - the utility sector is the second best performing sector after energy. But an article by Andrew Bary in this weekend's Barron's (paid subscription required) argues that utilities are now overvalued. His key points, and how to play this with ETFs:
Roger Bary's arguments against utility stocks:
- Utilities are trading at 16 times projected 2005 profits, in line with the S&P 500.
- That's the highest forward P/E relative to the S&P in 20 years.
- Utility stocks are only expected to grow earnings by 3-5% annually in coming years.
- That gives the utilities the highest P/E to growth ratio of any sector: over 3, versus 2 for the S&P and 1.5 for financials.
- Utility stocks have been driven higher by investor looking for dividend-paying stocks.
The bull case for utility stocks:
- The overbuilding of power plants and excessive financial leverage of the '80s have been corrected.
- M&A activity in the sector should help the stocks.
- Utilities face lower revenue risk than more cyclical stocks if the economy turns down.
- Warren Buffett likes them, saying in a recent CNBC interview that utilities are a "reasonable place to put money...it's not going to be a place to get rich, but it's a place to stay rich, and that's the way we look at it."
If you accepts Bary's bear case against utilities, how can you play this with ETFs?
Answer: short IDU, XLU or UTH. Advantages of using sector ETFs to short utilities instead of individual stocks? Less risk than with individual stocks, and the expense ratio works in your favor. (The annual expenses for the funds are deducted from the dividends you'll have to pay if you're short them.)