Utilities are offering a decent risk-adjusted return during the current economic turmoil. Current low treasury yields have shifted the attention of income seeking investors to healthy dividend offering utilities. As long as treasury yields remain low, we believe utilities will remain attractive for income seeking investors. There are some concerns regarding the high valuations of utilities, but we believe that valuations are not as high, considering the current economic environment. Utilities are low beta stocks offering high yields. We believe that these stocks have a self-corrective mechanism through which their price adjusts to their dividends (as the stock prices rise dividend yields fall).
Utilities are low risk businesses, with slow growth and a stable revenue base. Utilities ETF (XLU) has a beta of 0.48. XLU replicates the price performance and yield patterns of the stocks in the Utilities Selector Index. Its top three holdings are Duke Energy (DUK) (9.24%), Southern Company (SO) (8.84%) and Exelon Corp. (EXC) (6.67%). The prevalent sluggish economic environment has lowered the risk taking ability of investors. A steady revenue base and robust dividends in this low-yield environment make utilities an attractive investment for investors.
XLU is currently trading near $36, with a 52-week range of $33.18 to $38.54. In the last 6 months, the fund has gone up 1.95%; coupled with a healthy dividend yield of 3.95%, XLU gives investors good risk adjusted returns in the current market conditions. XLU is currently trading at a P/E of 16x, which is slightly higher than other ETFs such as QQQ, at 15x, and SPY, at 14x. Utilities' P/E of 16x is also above that of its 5-year median of 13.4x. We believe that the slightly higher P/E of 16x for the fund is supported by the fact that it offers a higher dividend yield than other ETFs. The table below shows yield and P/E for several funds.
Spdr S&P 500 Etf Trust (SPY)
Select Sector Financial Select Sector SPDR Fund (XLF)
Spdr S&P Homebuilders Etf (XHB)
Utilities may appear to be slightly overvalued when we compare their P/E with that of other sector ETFs in the table above, apart from XHB. However, we believe XLU's P/E of 16x is supported by its high-dividend yield and low beta. Even if investors think that XLU is overvalued, there are individual utilities that offer better investment opportunities. These companies include DUK, EXC and First Energy (FE). These companies have cheap valuations and offer attractive dividend yields, even more than that of XLU.
Source: Yahoo finance
We recommend buying DUK due to its expected future synergies, cheap valuations, high-dividend yield and long-term adjusted EPS growth of 4% - 6%. We also recommend buying FE, which is a leading regional energy provider, because of its high yield, cheap valuations and decreasing debt level. EXC is another stock in the utilities sector that we recommend to investors because it has a diverse business structure, low debt to equity of 87%, cheap valuations and high-dividend yield.
If we look at the monthly performance of XLU, it was down 1.4% in the month of October. Week-over-week performance till October 31, 2012, for the fund displayed an outflow of $91.5 million, which represents a 1.5% decrease. We believe this was mainly due to concerns regarding the Sandy storm, which led to serious power outages. According to some estimates, around 10 million people faced power outages due to Sandy. Companies are currently undergoing power restoration efforts. Regardless of where the storm hit, it had a negative impact on the companies' bottom lines due to storm-related costs. According to Moody's analysis, Sandy resulted in $50 billion in economic losses, and utilities and transportation loss is expected to be around $0.7 billion.
Despite concerns regarding high valuations and the impact of the Sandy storm, we have a bullish stance on utilities because they offer high dividends with low risk levels. We recommend dividend-seeking investors buy XLU and other individual company stocks like DUK, EXC and FE.