All But The Most Conservative Investors Should Skip VPU

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About: Vanguard Utilities ETF (VPU), Includes: FUTY, XLU
by: Strubel Investment Management
Summary

The utility sector is trading at above market multiples with below market growth.

The outlook for increasing energy usage is dim and the utility sector is becoming increasingly indebted.

Conservative investors who may want exposure to the sector should consider the Fidelity offering instead of Vanguard.

The Vanguard Utility Index Fund (VPU) is a sector fund that all but the most conservative investors should avoid. Let’s first start with why the utility sector as a whole doesn’t look like a promising place to invest. Then we’ll go over some differences between the Vanguard utilities index fund and other competing utility sector funds.

Expensive with No Growth

As of this writing and according to Yardeni Research, the utility sector trades at a forward P/E of 18 compared with 16.5 for the S&P 500. The problem is the prospects for growth do not seem to warrant an above-market multiple for the sector.

Electricity generation (good proxy for usage since generation can’t be easily stored) in the US has reached a plateau after the recession.

U.S. annual net generation

(Graphic source: Record U.S. electricity generation in 2018 driven by record residential, commercial sales - Today in Energy - U.S. Energy Information Administration (EIA))

Additionally, demand will likely remain subdued as homes and businesses become more energy efficient. Electric usage intensity for both residential and commercial users is expected to fall. Any growth in household formation or GDP may be offset by increasing energy efficiency.

(Graphic source: Electricity intensity of U.S. homes and commercial buildings decreases in coming decades - Today in Energy - U.S. Energy Information Administration (EIA))

If all of that is not bad enough, one other issue caught our eye. The utility sector as a whole does not seem to generate a substantial amount of cash flow in excess of its capital expenditure requirements. Despite flat lining energy usage, the top ten companies in the sector have seen capital expenditures grow by 7.7% per year over the past few years while revenues grew just 2.3% on average. Additionally, the financial profile of the sector declined as well, leaving the sector as a whole more heavily indebted. Debt to equity ratios rose almost 20% while financial leverage ratios rose 7.5%.

(Source: Morningstar, author’s calculations)

There are arguments to be made that eventually the costs for all of the new capital spending will be recovered from ratepayers. But, the broad point remains the same: you have a sector that is characterized by little to no growth, increasing indebtedness, and trading at above-market multiples.

Even if investors insist on exposure to the utility sector, there is likely a better choice than the Vanguard Utility Sector ETF.

Vanguard vs. Competitors

Despite its reputation as a low cost fund provider, Vanguard doesn’t always beat the competition. In this case, Fidelity offers a substantially similar utility sector fund, The Fidelity MSCI Utilities Index (FUTY), with an expense ratio of .08% (compared to .10% for VPU). SSGA also offers a utility sector ETF, but the cost is greater at .13% and the fund holds 28 stocks compared to 66 for FUTY and 69 for VPU. Although, given the top heavy concentration of the utility sector, the inclusion of small-cap utility companies may not make a significant difference when it comes to long-term returns.

There is one interesting difference between VPU and FUTY. While both are benchmarked to the MSCI US Investable Market Utilities index, the Vanguard fund uses a version of the index with several restrictions. VPU is benchmarked to the “25/50” variation of the index ,which limits the value of any single stock in the index to 25% and the total of all stocks with a weighting of 5% or more cannot total more than 50%.

Right now, the distinction between the two versions of the index does not result in any differences. The largest single issuer in the MSCI Utilities index is Next Era Energy (NEE) at ~10% and there are only five total issuers with a weighting of 5% or more. The total weight of those five is a bit less than 35%. So, it appears that at least in the near and medium term, investors won’t need to concern themselves with the slight differences in the index each fund follows.

Summary

In summary, there does not seem to be a compelling reason for most investors to include a utility sector index fund in their portfolio (this is not to say an individual utility stock couldn’t be a good investment). If you are an extremely conservative investor, there is an argument to be made as the sector is considered “defensive”. However, for these very conservative investors, the Fidelity MSCI Utilities Index (FUTY) looks like the best product.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.