The upcoming end to the Fed’s various quantitative easing programs is having its way with a variety of high yielding sectors and assets classes. Everything from junk bonds to pipeline master limited partnerships have been shaken by the fear of rising interest rates. That includes some pretty boring widow and orphan stocks and well.
In this case, we’re taking about plain-vanilla utilities.
The companies that provide electricity, gas and water have all plunged in recent weeks as investors fled the safety of their high dividends towards other options. However, despite the fear of rising rates ahead, the utility sector still has much to offer investors and could now be one of the biggest bargains in the months ahead.
A Power-Full Bargain Brewing
The last year wasn’t too kind to the providers of power and water. Overall, the utility sector- as measured by the Utilities Select Sector SPDR (NYSE:XLU) -managed to only pull in a 12% annual return over the last year. That’s less than half of the amount of the S&P 500’s full-year return and makes the utilities one of the worst performing sectors sans commercial real estate.
Yet, that recent under performance may be just the buying opportunity income seekers need to load up on shares of the power producers as the sector could still see more gains ahead.
First, the fear of rising interest rates on utility shares may be a little overstated. Looking back over the last twenty years, data provided by Morningstar (NASDAQ: MORN) shows that 10-year treasury yields could rise by over 1% point before they would actually have an impact on utilities total returns. While the Fed’s tapering of its bond buying could raise rates, those rates won’t spike overnight. And with utilities yielding an average 4%- more than 1% above treasury bonds- coupled with their 3 to 5% earnings growth -could make for a nice total return package in the New Year.
Now could be the time to strike on the sector.
The Fed’s taper fears have pushed utilities down to their lowest valuations in almost two years. Since April, the utilities' average P/E ratios have fallen around 10%. That puts the providers of water, electricity and natural gas at a nearly 10% discount to the broad market. That’s versus a 5% average premium that’s stuck around since 2012.
Adding in the recent frigid weather, growth opportunities in alternative and renewable energy and recent rate hike awards and investors in boring utilities may come out ahead this year.
Snagging Power Producers
For investors, the utilities recent fall to cheapness could be a gift and now could be a prudent time to add the sector to a portfolio. While the previously mentioned XLU is the most popular choice, the Vanguard Utilities ETF (NYSE:VPU) maybe a better play. VPU offers a low-cost way to add an entire basket of power, water and electric companies to a portfolio.
The ETF tracks 77 utilities- including Dominion Resources (NYSE:D) and PG&E (NYSE:PCG) -and features Vanguards commitment to low-cost investing. VPU only charges a rock-bottom expense ratio of 0.14%. That’s significantly less than competing funds like the iShares US Utilities (NYSE:IDU) and First Trust Utilities AlphaDEX (NYSE:FXU).
Green and renewable energy is providing plenty of growth many utilities’ bottom lines. Stalwarts like Duke Energy (NYSE:DUK) and Southern (NYUSE:SO) have both been adding solar farms at a record clip. That will allow them to buy green energy at cheaper prices. For instance, Duke is able to save around 5 cents per Kwh when using its own solar plants. Likewise, NextEra Energy (NYSE:NEE) renewable energy muscle is well known as the firm is the largest producer of solar and wind power in the United States. All three firms yield in excess of 3%.
Finally, for those investors looking for turnaround plays, beaten down Exelon (NYSE:EXC) and FirstEnergy (NYSE:FE). Both are two huge nuclear power operators and recently cut their dividends in order to preserve cash in the current low-price operating environment. However, analysts now believe that their distributions are at stable levels and they two stocks could provide plenty of upside as their transitions take hold.
The Bottom Line
Shaken by the Fed’s taper announcements, the boring word of utility stocks seem to have been turned upside down. However, for those with longer times, the current weakness could be a prime opportunity to add some shares. The previous picks- along with Edison International (NYSE:EIX) –make ideal selections to play the utilities upside.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.