Why mini-boom for utilities is suspicious

Traders work on the floor of the New York Stock Exchange.

Utilities, what’s wrong with this picture?

Utilities are the best performers of the year, one of only two sectors in positive territory. The Dow Utilities are up about 7 percent, while telecom is up roughly 5 percent.

The S&P 500, meanwhile is down about 9 percent.

Some electric utilities have seen double-digit gains on the year:

Chesapeake Utilities – 16 percent

Con Ed – 14 percent

Duke – 11 percent

Xcel – 10 percent

It is little wonder that Janney Montgomery Scott utility analyst Michael Gaugler asked in a recent note to clients, “Is it time to re-position 2016 portfolios, already?”

Maybe. There are three reasons everyone is suddenly so hot for Utilities:

1) Yield

2) Utilities are a “safe” play

3) M&A activity

Let’s look at these claims:

1) Yield.

This is largely a “hunt for yield” story, and there definitely is something here. Most utilities have a 3 to 4 percent dividend yield.

But even companies with modest dividend yields have been strong this year. Good examples are water utilities like American Water Works,American States Wate and Aqua America, all up about 8 percent on the year despite very modest dividend yields of only roughly 2 percent. All hit historic highs last week.

They have ridden on the wave of investor uncertainty and the dramatic decline in 10-year Treasury yields, which have dropped from 2.3 to 1.7 percent this year.

But if you live by lower Treasury yields, you die by higher yields. OK, if you believe the Fed is doing nothing for the rest of the year, than keep buying utilities. But these stocks have a long history of dropping fast when the markets even think rates are going up. For example, utilities dropped 12 percent in the early part of 2015 when 10-year yields went from roughly 1.65 to 2.2 percent.

In other words, this stuff can head south fast if there is a change in rates, or even the perception of a change in rates.

2) Utilities are a “safe” play.

They are safe, if by “safe” you mean the companies will not go bust, and their dividends are relatively safe. They do try to increase their dividends; most utilities are growing dividends 5 percent or so a year.

But if by “safe” you mean “these stocks are unlikely to go down,” well, now you’re in different territory.

For these stocks to keep going up, you have to make two assumptions:

a) that rates will keep moving lower, and

b) that investors will keep fleeing the broader market.

I’ve already noted that you are taking a risk assuming that rates will keep going lower. But I think you are also taking a risk assuming that investors will just keep fleeing everything else and piling into utilities.

That’s because the belief that utilities will keep outperforming through a down market is, well, historically suspect as well. A hedge fund friend of mine who has been trading utilities and energy stocks for years had this to say: “One of the things we have observed by studying these stocks across several different bear markets is that they provide protection only in the early stages of the bear, but have never really been good preservers of capital by the time the bear is done wreaking havoc. So it can indeed be dangerous to overstay one’s welcome in these names and we have been harvesting our longs in the space for that reason.”

3) M&A activity is heating up.

There is some truth to this, but because there is so little to acquire it likely won’t last long.

There are three parts to the utility business: power generation (gas, nuclear, coal), transmission (the long-distance wires), and distribution (getting the juice into homes). The trend in recent years is for the big integrated power companies like Duke, Southern, Eversource andDominion to own everything: transmission, distribution and power generation.

So these integrated companies have been buying things recently to round out their portfolios. Today, Fortis, a Canadian utility, bought ITC Holdings, which owns transmission lines. And many utilities have been snapping up gas distributors. Southern Company bought gas distributor AGL Resources, Duke Energy bought Piedmont Natural Gas.

Why gas distributors? Gas is a simple business. Dry gas goes through pipelines, it’s much less capital intensive than power generation. You don’t have to run a power plant. There’s an installed base of customers.

But this won’t last: there’s just not much left to buy.

That leaves me with my last problem with utilities: these stocks are expensive by historic standards. P/E valuations for many names are at or near historical highs, with most trading north of 20. For a utility?

So you have an industry with: little or no growth, historically high valuations, and extreme sensitivity to changes in interest rates.

Look, I get how these are being sold. You can hear the pitch from Wall Street to worried investors: “Look, Mrs. Smith, utilities are a monopoly. You get a dividend of 3 or 4 percent, and it never goes down. The companies won’t go under — it’s the gas company, for cryin’ out loud! So you start with a dividend of about 3 percent, and most of these companies have earnings growth of 5 percent a year, so it’s fair to assume you get yearly returns of 8 percent, relatively risk-free.”

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