The Often Overlooked Danger When Investing In S&P 500 Utility Stocks – Part 10A

2015-03-06

Introduction

The S&P 500 is a large and broad index that includes 10 broad sectors and many types of individual companies. Many S&P 500 constituents pay dividends and many do not. One of the smallest sectors by weight is the Utilities Sector, comprising just over 3% of the total index, and includes 29 constituents. However, one distinguishing characteristic of this sector is that every constituent pays a dividend. As such, every constituent of the S&P 500 Utilities Sector might, or could be, of interest to retired investors or dividend growth investors looking for income.

There are other distinguishing characteristics of utility stocks that might also make them appropriate candidates for long-term buy-and-hold (invest and own) conservative investors seeking income. Many, not all, but many utility companies operate under a regulated environment for some or a large portion of their businesses. Consequently, the utility industry has a reputation for safe, stable dividends and predictable operating results. The legendary investor Warren Buffett is one that holds this view. For example, in his most recent letter to shareholders of Berkshire Hathaway (BRK.A) (BRK.B), Warren Buffett specifically addressed his utility-oriented holdings as follows (the emphasis added is mine):

“A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each company has earning power that even under terrible economic conditions will far exceed its interest requirements.”

“The first is common to all utilities: recession-resistant earnings, which result from these companies offering an essential service on an exclusive basis. The second is enjoyed by few other utilities: a great diversity of earnings streams, which shield us from being seriously harmed by any single regulatory body.”

Although Warren Buffett was specifically talking about Berkshire’s holdings, the important attributes he highlighted generally apply to the Utilities Sector. However, the reputation for safety and stability that utility stocks have long held is evolving. Many utility stocks have been diversified into non-regulated businesses, and therefore, the old view of the Utilities Sector is evolving. Consequently, I believe that prospective investors should carefully examine the specific attributes of each individual company in this sector, just as they would with companies in any other sector.

The S&P 500 Utilities Sector

The Utilities Sector makes up just over 3% of the S&P 500 index, and as such, is one of the least important components. The following is a brief description of the types of companies in the Utilities Sector, courtesy of Investopedia:

DEFINITION of ‘Utilities Sector’

A category of stocks for utilities such as gas and power. The utilities sector contains companies such as electric, gas and water firms and integrated providers.

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General Characteristics of Utility Stocks

There are a couple of facts regarding investing in utility stocks generally that I would like to simply mention here and elaborate more on later in the article with specific examples. First and foremost, almost by definition utility stocks tend to have very low historical rates of earnings growth. Therefore, if bought at fair valuation, the capital appreciation component for the long-term buy-and-hold (invest and own) investor will correlate very closely to the company’s historical rate of earnings growth.

Consequently, there is not much of a margin for error because even a modest amount of overvaluation can significantly lower or even negate any potential future capital appreciation. Additionally, current yield will be lessened, and risk increased if you overpay for a utility stock even by just a little bit. This is an often overlooked danger when investing in utility stocks.

Additionally, utility stocks are generally favored for their above-market current yield. On the other hand, since there is a relatively high correlation between dividend growth and earnings growth, the benefit of a higher-than-average current yield is moderately negated by a lower-than-average dividend growth rate. This represents another important reason why you should be diligent and careful to not overpay for utility stocks.

The 29 S&P 500 Utilities Sector Constituents

Below, I will be featuring specific examples of the 29 S&P 500 Utilities Sector constituents that possess differing investment characteristics and relative valuations. To facilitate this, I have organized the F.A.S.T. Graphs portfolio review on the S&P 500 Utilities Sector constituents by alphabetical order.

There are three columns on the following “Portfolio Review” that I suggest readers carefully analyze in order to ascertain a feel for the relative current valuation of the companies in the S&P 500 Utilities Sector. Look at the current P/E ratio in relation to each company’s historical 15-year normal P/E ratio (15Y N P/E) to get a general sense of whether each company, statistically at least, is overvalued, fairly valued, or even undervalued.

Ideally, the current P/E ratio should be at least equal to or lower than the company’s historical normal P/E ratio. Finally, a quick glance at the dividend yield on each company can provide an additional first blush sense of current valuation. In theory, the higher the yield, the lower the valuation, ceteris paribus.

However, I caution that although this analysis will give a general feeling or sense of current valuation, since the “Devil’s in the details,” these broad statistics can be misleading. Therefore, later in the article, I will provide a few specific examples to more elaborately illustrate this important point.

Regardless, this general stereotype regarding utility stocks, especially regulated electric utilities, that they are slow growers, is an important consideration to keep in the back of your mind at all times when considering utility stocks for investment. When you peruse the 15-year historical earnings growth rate column (15Y EPS Gwth), you would discover that there is a general truth to this previous statement. However, you also discover that there are exceptions to the stereotype. Once again, validating the importance of comprehensive due diligence on the specific business over a more general or statistical analysis.

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Dominion Resources, Inc. (D)

With my first featured company, I present an example of a high-quality S&P 500 utility constituent that I believe is currently overvalued. Although the company does offer a very attractive current yield of 3.6%, its current P/E ratio of 20.5 is historically high. A careful examination of the graph would indicate that earnings growth over the last couple of years has also been above historical norms.

Perhaps this fact and the consideration that investors are seeking yield in today’s low interest rate environment might explain this company’s abnormally high valuation over the last couple of years. On the other hand, I would argue that fundamentals do not support today’s high valuation. With my next graph on this company, I will highlight the intermediate risk this suggests.

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With this next graph. I have shortened the time frame in order to more clearly calculate the potential intermediate risk of investing in Dominion Resources at today’s high current valuation. If the company’s stock price returns to its more normal 15 P/E ratio, this would calculate to a -6.03% total return out to fiscal year-end 2016. Even though the future estimated dividends would equate to $4.89, the potential capital loss of $12.53 would generate the negative total return.

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FirstEnergy Corp. (FE)

My second example of an S&P 500 utility constituent to illustrate an exception to the safe and stable reputation of utility stocks discussed above is FirstEnergy Corp. With this particular utility, we see declining earnings starting with the Great Recession that ultimately led to a dividend cut in 2014.

Therefore, I caution prospective investors that might be attracted by today’s low P/E and high current yield to be aware of this company’s historical earnings and dividend record.

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NextEra Energy, Inc. (NEE)

I feature NextEra Energy to illustrate an example of a utility stock that has achieved higher earnings growth than we find with the typical utility. Nevertheless, I also consider this S&P 500 utility constituent overvalued currently. The reader should note what occurred the last time this company was overvalued as it entered the Great Recession.

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At this point, I think it’s important to repeat an important disclosure about utility stocks. As a general rule, but with exceptions, regulated utilities do not offer much growth of either capital or dividend income. Accordingly, overpaying for companies in this sector even by just a little bit can reduce long-term returns to what many would consider unacceptable levels relative to the risk taken.

On the other hand, the above-average and stable dividend yields that many utility stocks offer can provide a modest but positive return. In other words, I am suggesting that utility stocks are an equity asset class where paying attention to fair valuation is more critical than it would be, for example, with a stronger-growing consumer staple. With my next example, I will provide the reader the opportunity to comprehensively evaluate that last statement.

Southern Company (SO)

As most of my regular readers know, I routinely illustrate my investing thesis on individual stocks by utilizing the fundamentals analyzer software tool F.A.S.T. Graphs, which I co-founded. When I include an earnings and price correlated graph on a company in an article, I have only been able to offer a picture of a fully functioning graph. And, for most of the examples in this article, I have done the same.

However, with this featured high-profile utility stock Southern Company, I offer a fully functioning, live and interactive F.A.S.T. Graph. This will empower loyal readers who are non-subscribers to more comprehensively analyze the historical operating results of Southern Company and to run numerous performance calculations in order to better understand my points about overpaying for utility stocks mentioned above.

The future return potential for this year and next can also be calculated by pointing to the last price dot on the graph until it turns red, and then point to either one of the forward triangles on the orange earnings justified valuation line and a potential future performance calculation to include dividends will be generated.

The orange horizontal column at the top of the graph will allow you to evaluate Southern Company over multiple time frames since 1996. Just point and click on any of the numbers (for example 5Y), and the earnings and price correlated graph for that time frame will be instantly drawn and earnings growth rates and adjusted historical normal P/E ratios are revealed in the box to the right of the graph.

Note that all graphs are produced in calendar years and include the current year, plus one year of forecast. However, the data is presented based on fiscal year reporting, which in this Southern Company example is December.

The reader can also point to any price (the black line on the graph) and a pop-up will appear with the date, price and P/E ratio at that time. You can also click on any price point (point A, a red dot will appear) and then click on any other price point on the graph (point B) and performance calculations to include dividends will appear. With this example, I suggest running performance calculations from periods of time when the stock is modestly overvalued (when price is above the orange valuation reference line) and then point to time frames when valuation is in alignment (price touches the orange line) and experience the impact of even modest overvaluation on long-term performance.

The legend at the bottom of the graph (orange rectangle) is also interactive. If you look closely, you will see the grayed out words “Dividend YLD.” If you click on those words, a dividend yield overlay will be added to the graph. This provides an additional valuation measurement that can be analyzed. To be clear, a higher dividend yield will correspond to a lower price valuation and vice versa. You can also add and delete the various metrics found in the orange rectangle by simply clicking on them. For anyone interested in learning more on how to navigate the graph, follow this link.

SCANA Corp. (SCG)

To additionally support my thesis about being careful with valuation when considering utility stocks, I offer SCANA Corp. The reader should note that the company’s stock price performed exceptionally well in 2014, but rose above its normal earnings justified fair value (the orange line). Consequently, since the beginning of 2015, the company’s stock price is clearly reverting to the mean. This has resulted in the stock price falling approximately 13% since the beginning of 2015. Investors need to be careful about valuation when investing in low-growth, high-yielding utility stocks. However, I do believe this reversion to the mean has brought SCANA Corp. close to an attractive entry point currently.

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Wisconsin Energy Corp. (WEC)

Wisconsin Energy Corp. is another one of my favorite utility stocks. In similar fashion to NextEra Energy, this utility has provided consistent above-average earnings and dividend growth relative to most utilities. This excellent record has attracted many fans of this high-quality utility stock that is also one of the purest examples of a true regulated utility.

However, as much as I admire this particular utility stock, it’s important to acknowledge the high valuation that the market is currently applying. As I have often stated in the past, you can pay too much for even the best of companies. If this company were to return to a more normal fundamentally justified P/E ratio, this would indicate negative intermediate-term future returns.

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Summary and Conclusions

Generally speaking, it is somewhat true that utility stocks, especially regulated utility stocks, share certain characteristics that differentiate them from the typical dividend growth stock. However, these common characteristics are not all necessarily positive. On the plus side, utilities are thought of as predictable stocks with low volatility characteristics. Utility stocks also tend to provide a higher current yield than many dividend growth stocks.

On the other hand, all of this consistency comes at a sacrifice of growth. Since the typical utility has a significant portion of their businesses regulated, their ability to grow earnings and dividends is restricted. And as indicated in the article, these characteristics do not universally apply to all utility stocks.

In Part 1 found here, I presented a valuation overview of the S&P 500. In Part 2, I reviewed the Energy Sector component of the index, and in Part 3, I reviewed the Information Technology Sector. In Parts 4A and 4B, I reviewed the Financial Sector, and in Part 5, the Healthcare Sector. In Part 6, I reviewed the Consumer Discretionary Sector. In Part 7, I reviewed the Industrials Sector of the S&P 500. In Part 8, I reviewed the Consumer Staples Sector. In this Part 9, I reviewed the Materials Sector. In this, Part 10A, I reviewed the Utilities Sector. In Part 10B, I will review the Telecommunication Services Sector.

Disclosure: Long SCG, ED, NEE, GAS at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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