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In a volatile market and a questionable global economy, many investors judiciously turn to defensive utility stocks paying a fat dividend. The counter-argument would be that large regulated utility companies have limited growth opportunities and are thus more sensitive to interest rate hikes where investors will show preference for higher-yielding bonds. The other side of the table would pipe up and say that many utility holding companies have significant unregulated portions, and some of the company diversification involves non-energy. If you buy during periods of good value, you will not be as likely to sell and switch to bonds when interest rates are higher with suppressed utility share prices.

The take home message is that despite buying defensive utility stocks, you still need to consider valuation (and possibly growth) to ensure you are not buying over-valued stock in a firm with little upside or an anemic dividend. Before jumping into the utility recommendations … I first need to briefly discuss how the utility portfolio is created and what a suitable benchmark is.

Utility Benchmark

The Utility Sector Select SPDR (XLU) will serve as an adequate benchmark for our discussion. Below is a chart showing 10 years of total returns.

A total return of 153.1% is impressive although these stocks were not immune to the bear market that took down prices 45%. This translates into a 9.64% compound annual growth rate.

Yield, Valuation and Correlation

I keep it fairly simple when creating a utility stock strategy. First, I only select from the top 10% dividend yields when looking at all stocks in the market. Low yields do not always mean an overvalued share price, but I prefer to be income-focused with this strategy. This will discount some utilities such as Clean Energy Fuels Corp. (CLNE) that are not providing dividends as they build out the natural gas highway for a higher risk/reward scenario than most other utilities.

Next I look at valuation with the aid of a ranking system that separates bull and bear markets. In a bull market, a firm is ranked higher based on growth, value and sentiment metrics while a bear market will favor utility stocks with high quality earnings and low price volatility. The S&P 500 forecast earnings for the current year (see chart below) have slumped since May. In July the 'down market' signal was issued which means we will focus on quality and volatility.

(Click to enlarge)

The last aspect is a nod to Modern Portfolio Theory, even though I am not their biggest supporter. Any new stock added to the portfolio should not be highly correlated to the price movement of the portfolio. The goal is to have 'share price diversification' for a smoother portfolio ride.

Which of these portfolio rules are the most important? My testing has shown the yield to be the most important aspect followed by the comprehensive valuation ranking system and lastly (as well as minimally) the correlation. You can read more about the inner workings of the Defensive Utility portfolio here.

Recommended Stocks

Exelon Corporation (EXC) - The rising yield is now at 5.5%. Although price has been slumping, beta is still fairly low (between 0.46 and 0.52) and the analyst estimate ranges for the current year are fairly tight. In unstable markets you want to keep guessing as low as possible as the unknown often leads to higher volatility. I don't like the falling returns, lowered analyst estimates and rising PE ratios (due to lowered profits and not rising prices). Still, in light of dividend yields, decent value and low recent forecast earnings revisions and price volatility - I recommend this a one of the holdings which was initiated on July 9th 2012 with a 1.31% return to date.

*The chart below shows the PE 10 ratio rather than the 12 month trailing

PPL Corporation (PPL) - This utility company has a strong forward yield of 4.9% on a sub 50% payout ratio and a deep value price to earnings ratio of 10. While this is a stock with a very low beta of 0.15 there are a couple of reasons why it is being kept on the "watch list." Earnings have been all over the place, the company carries a significant amount of debt and has negative FCF. Its "deep value" is the saving grace and has been included in the recommended portfolio since June 25th 2012 and has returned 8.43%.

Public Service Enterprise Group Inc. (PEG) - A trailing PE ratio of 12, a forward dividend yield of 4.4% with a payout ratio of 53%. Why is this being included as a stock for the utility portfolio? As regards stability … there has been very little change in the current year estimate, the long-term growth rate range is tight (partially because it is low though). FCF has taken a beating last quarter which isn't optimal and ROE has been in steady decline over the past 3 years. This is a value play with good yields on low payout ratios with lots of breathing room to maintain income.

Duke Energy Corporation (DUK) - It may come as a surprise that Duke Energy is not a stock I am recommending at this time. Why? It ranks too low on my fundamental ranking system. The debt is too high, the trailing PE ratio is close to 20, and the changes in standard deviations over the past 3 months makes this one to watch but not hold quite yet.

Utility Portfolio Performance

The Defensive Utility portfolio has been a strong performer over the past 10 years. Some of the ranking rules have created higher turnover than some income investors like, but I feel that the trade-off of low volatility, small draw-down and higher than average returns adequately compensates.

The following chart is complements of Portfolio123:

(Click to enlarge)

If you compare this to the Utility SPDR you will notice that the CAGR in this portfolio is over double with far less draw-down. This sort of strategy is suitable for income investors who are willing to actively manage their portfolios and at times hold a high percentage of cash.

Source: Utility Stocks - 3 To Consider And 1 To Wait On