U.S. Utilities: Don't Overpay For Yield

Includes: DVYE, HDV, IDV, IXP
by: Russ Koesterich, CFA

As short-term interest rates remain at or close to zero, investors starved for income should be wary of overpaying for yield, particularly when it comes to U.S. utilities. As I write in my new Investment Directions monthly commentary, I continue to prefer dividend funds and the global telecommunications sector for investors searching for yield. But some segments of the market - such as U.S. utilities - are looking expensive and should likely be avoided.

I continue to hold an underweight view of U.S. utilities for two reasons:

1.) Valuation: Investors have pushed U.S. utility stocks up too far as U.S. utilities currently look even more expensive than they were back in January. U.S. Utilities are currently trading at nearly 15x earnings, versus an average since 1995 of around 14.5x. And the stocks are even more expensive when you compare their valuation to the broader market. As a regulated industry, utilities typically trade at a discount to the broader market. Since 1995, U.S. utilities have traded at an average discount of roughly 25% to the S&P 500. Today, however, U.S. utilities are currently trading at a more than 8% premium, the largest since late 2007.

2.) Profitability: The premium can't be justified by U.S. utilities being more profitable than in the past. In fact, the U.S. utilities industry is currently less profitable than its long-term average. Return on earnings for U.S. large cap utility companies is currently 10.5%, the lowest level since 2004.

So why are investors paying a near 10% premium to invest in a sector whose profitability is close to an eight-year low? The answer: U.S. utilities have benefited from investors' flight to safety and flight to yield. To be sure, if the market experiences a major correction, U.S. utilities would likely outperform given their low beta (a measure of the tendency of securities to move with the market at large). However, absent a major correction, I believe a combination of stretched valuations and lackluster profitability suggests that U.S. utilities are likely to continue to trail the market, even in a slow growth environment.

As I wrote in a recent post, my preferred vehicles for seeking yield are dividend paying equities, such as the iShares High Dividend Equity Fund (NYSEARCA:HDV), given its low beta and quality screen; the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA:IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA:DVYE). For investors willing to take the added risk of sector exposure, I like the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA:IXP).

And for investors still looking for exposure to utilities, I continue to hold a neutral view of global utilities, particularly international ones available through the iShares S&P Global Utilities Index Fund (NYSEARCA:JXI).

Source: Bloomberg

Disclosure: The author is long HDV, IXP, IDV.

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