The Select Sector Utilities ETF: Plugging Into Solid Total Returns

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Includes: AEP, D, DUK, ETR, EXC, FE, FPL-OLD, PCG, PEG, SO, XLU
by: Paul Price
The Select Sector Utilities ETF (NYSEARCA:XLU) seeks to replicate the performance, net of expenses, of the Utilities Select Sector Index. The fund invests at least 95% of assets in common stocks that comprise the index. The index includes companies from the electric utilities, multi-utilities, independent power producers, energy traders and gas utility industries.
XLU has an extremely low expense ratio of just 0.22% and has done a good job of tracking its underlying index. It has outperformed the overall S&P 500 over the past 5 and 10 year periods and is well ahead of its peer group over the past decade.
Annualized to 1/31/10
XLU
Peer Group
S & P 500
5-Years
4.01%
4.18%
(-0.06%)
10-Years
5.35%
2.74%
(-0.69%)
Here are XLU’s top 10 holdings (by percentage of portfolio) along with their current P/Es and their 10-year median multiples:
Company
Symbol
% of Portfolio
Current P/E
10-Year P/E
Exelon
8.46%
10.1x
15.1x
Southern Co.
7.20%
13.6x
15.0x
Dominion Res.
6.29%
12.7x
16.0x
FPL Group
5.67%
11.8x
14.0x
Duke Energy
5.59%
14.4x
15.6x
Amer. Elect.
4.68%
11.1x
13.0x
PG & E
4.43%
12.9x
14.0x
Pub. Ser. Ent.
4.35%
9.6x
13.0x
Entergy
4.05%
12.0x
14.0x
FirstEnergy
3.74%
11.7x
14.0x
Group Average
12.0x
14.4x
In every case, the present P/E is significantly lower than that same company’s 10-year median multiple. The yield on the whole XLU portfolio is now about 4.37% - a higher rate than can now be obtained through purchase of Treasury Bills and Notes of up to 10 year maturities.
If the utility sector reverts back to its own 10-year average P/E of 14.4 we could see about a 17% share price improvement (due simply to multiple expansion) above and beyond any rise in the shares attributed to future increases in earnings or higher dividends.
After the big rise from the March 2009 market lows I think it’s unlikely that the average stock will continue to perform as well as it did in the previous year. That slower-paced market environment should make slow and steady utility shares more attractive on a relative basis than they were when most lower-quality and low/no dividend shares were surging higher.
As such, this appears to be an opportune time to own a basket of utilities such as XLU’s that provides a diversified way to play the group at a low cost and with a decent income component.
I’m looking out about two years to allow time for the "reversion to the mean" in P/E to take place while I collect the better than 4% yield on these XLU shares. A total return of 25% or better seems likely over the next 24 months. Not too bad for a conservative investment in a virtually zero interest world.
In the early day sell-off this morning I was able to (write) sell some January 2012 $30 puts for $4.85 /share giving me a break-even point of $25.15 when the shares were changing hands at $28.90 /share. If the XLUs merely rise to $30 or higher by the January 2012 expiration date I’ll pocket the entire $4,850 (from the sale of 10 contracts) without ever having actually bought the shares.
In a worst-case I’ll end up being forced to buy 1000 shares of XLU at a net cost of $25,150 versus the $28,900 they would have cost me even during this morning’s big market drop.
Disclosure: Author is long XLU shares and short XLU puts.

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