The utility sector has been struggling in recent months.
Between April 30 and September 17 (the day before the September
18 FOMC announcement), the total return for the Dow Utility index
was off 7.5%. The rise in 10 year treasury yields and fear
of Fed QE taper weighed on this interest rate sensitive sector.
The S&P 500's total return was up 7.6% over the same
time period. The difference between the two total returns
underscores the lagging nature of the utility sector.
The yield spread is attractive for utilities:
Although the utility sector has been a soft performer, the
sector continues to provide a favorable yield alternative to the
10 year treasury and Baa corporate bond yield. The yield on
the Zacks Utility Sector index was about 3.65% against a 10 year
yield near 2.70% and a Baa corporate yield below 5.50%. A
Baa corporate is a medium grade debt instrument which is neither
highly protected nor poorly secured. The spread between the
utility dividend yield and the fixed income alternatives remains
near the upper end of the 15 year range. The first graphic
displays the spread without the impact of taxes. The price
of the utility index is plotted on the second y-axis and
inverted. Loosely speaking, it shows drop in the utility
less 10 year treasury and utility less Baa corporate spreads
leading to higher utility sector prices and rising spreads
leading to lower utility sector prices.
Through much of the period between the mid 1990's and mid
2000's period, utilities carried a yield below that of
treasuries. The sector also carried a spread less than
2.50% to the Baa corporate. The chart suggests the spreads
are not overly elevated compared to the post Great Recession
period, but high compared to most of the time frame in the
graphic. Utilities look cheap to fixed income, especially
if dividends in the sector can rise over time. To
some extent, it looks like the sector is taking some protection
against higher corporate and treasury rates.
Spreads with taxes:
Beyond a straight yield spread, it might be worth looking at
tax implications. Qualified dividends are taxed at a lower
rate than ordinary income (coupon payments) for a large number of
investors. Dividends are taxed at 15%, while ordinary
income is taxed at 25% or more for joint filers with incomes over
$72,500, and individuals making more than $36,250 per year.
The dividend tax jumps to 20% and the tax on interest
income surges to 39.6% for high income earners. The graphic
displays the difference in yields on an after tax basis.
The highest dividend tax of 20% is applied to utilities, while
the top marginal tax rate of 39.6% is applied to the treasury and
the Baa corporate. The new Medicare tax of 3.8% on
investment returns was left out, but is present for both
dividends and interest income for individuals and families over
$200,000 and $250,000 respectively.
The general conclusion on relative value is about unchanged
looking at the spreads with and without taxes, but there is more
return pick up in the utility sector due to the favorable tax
treatment of dividends.
The Fed Factors:
Given that the Fed has surprised the markets by keeping its
asset purchase program in place at full level, investors are
likely to warm toward yield grabbing. A recent survey by a
major broker indicated that investors were underweight the bond
sector by the largest amount since 2006. Investors may up
their allocation to fixed income and debt linked investments.
In his press conference on September 18, the Fed Chairman
seemed to suggest that the Fed will keep rates low for a long
period and would not box the Fed into the timing of
tapering. This type of statement may support the search for
yield and put utilities on the investment table. Carry or the
opportunity cost of holding cash, remains favorable for dividend
Ways to play with ETFS:
In order to earn yield in the utility sector, investors could
put money in a utility based ETF. There are a number
available. Here are a few choices:
The SPDR Utility Select Sector ETF (
) offers exposure. It is a market capitalization weighted
ETF. It has a heavy concentration in Duke Energy (
), Southern (
), Nextra Energy (
), and Dominion Resources (
) - over 30%. There is not much focus on earnings in this
ETF, and it is a slice of the S&P 500.
PowerShares has a Dynamic Utility ETF (
). This is a "smart" ETF in that its weights are based on
price momentum, earnings momentum, management action, and
value. However, this name spreads holdings outside of the
pure utility sector with DISH Networks (DISH), Sprint (S) and
Comcast (CMCSA) a few untraditional utility names in the
portfolio. It classifies communications related stocks as
Guggenheim has an S&P 500 equal weighted utility index (
). This provides a broader exposure to the utility sector - less
Vanguard has a utility ETF (
). It is concentrated in large cap names like the XLU, but to a
Ways to Play with Stocks:
Utilities tend to be yield plays, but there are a number of
companies which are a Zacks Rank #2 (Buy). Utilities can
benefit from growth trends and operational efficiency, and the
Zacks #2 rank implies there are utility stocks seeing their EPS
projections revised higher. Thus, it may be possible to get
some growth and yield for a healthy total return.
The table following displays a list of
Zack Rank #2
utility stocks, their dividend yields, and the trend in their
earnings estimate revisions. Notice that Integrys Energy (
) and UNS Energy (
) have the highest dividend yields and relatively high payout
ratios for fiscal year 2013.
(click table to enlarge)
It seems like Idacorp (
) and PNM Resources (
) have the largest room to lift their dividends based on their
payout ratio. As a refresher, the payout ratio is equal to
the dividends per share paid divided by earnings per share.
It is a simple measure of dividend sustainability.
Dividends paid relative to free cash flow may be a better read of
payout stability, but shifts in capital spending can make this a
volatile and sometimes a not meaningful indicator.
There have not been a great number of earnings revisions in
the sector. The table highlights that NV Energy (
) has seen the only upward revision in the last 30 days.
The next table highlights valuation in the sector. Notice that
Integrys Energy and UNS Energy are trading closest to their long
term PEG ratio. TEG looks marginally cheap to the group,
but valuations would be more attractive if the names were trading
at a discount to their longer term PEG ratios.
(click table to enlarge)
Like the PEG ratio, most of the names are trading at a premium
to their median tangible book value per share value.
Idacorp was trading equal to its median and looked relatively
cheap to the group. Northwest was next with a small 4.2%
Given the general search for yield and a cautious view toward
the equity market by the public, it seems like utility valuations
are firm - the sector is does not look cheap relative to its
historical earnings and book value measures. The value
seems to rest in the dividend yield levels relative to treasuries
and corporate debt.
In terms of relative value and dividend yield, the table
following highlights a matrix of values and averages for each
name. A value of 1 was given to the company with the most
bullish fundamental measure, while a value of 5 was given to the
company with the most bearish fundamental measure. In this
case, a low PEG ratio, low price to book value, and low payout
ratio were seen as bullish. In contrast, a high dividend yield
was viewed a bullish.
(click table to enlarge)
Based on this simplistic approach, which is arguable as a
stock picking tool, Idacorp and Integrys Energy scored strongest
in terms of the mix of value and yield. The table helps to
provide some clarity on the mixture of measures examined and
helps draw a conclusion.
Utilities remain attractive relative treasuries and corporate
debt. Those looking for broad exposure may want to choose
an ETF, but for those looking for some growth and income and like
individual names, Idacorp and Integrys Energy are worth
examining. These are Zacks Rank #2 shares which pay yield
and appear attractively valued relative to their peers. Let
utilities power up you portfolio.
DOMINION RES VA (D): Free Stock Analysis
DUKE ENERGY CP (DUK): Free Stock Analysis
IDACORP INC (IDA): Free Stock Analysis Report
NEXTERA ENERGY (NEE): Free Stock Analysis
NV ENERGY INC (NVE): Free Stock Analysis
PNM RESOURCES (PNM): Free Stock Analysis
PWRSH-DYN UTIL (PUI): ETF Research Reports
GUGG-SP5 EW UTL (RYU): ETF Research Reports
SOUTHERN CO (SO): Free Stock Analysis Report
INTEGRYS ENERGY (TEG): Free Stock Analysis
UNS ENERGY CORP (UNS): Free Stock Analysis
VIPERS-UTIL (VPU): ETF Research Reports
SPDR-UTIL SELS (XLU): ETF Research Reports
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