Danger Zone: First Trust Utilities AlphaDEX Fund ETF (FXU)

Making matters worse, POM’s current valuation of ~$27/share implies that the company will grow after-tax profit (NOPAT) by 5% compounded annually for 26 years. Seeing as how POM has only grown NOPAT by 2% compounded annually for the past decade, the market’s expectations appear overly optimistic.

One last issue with FXU: In addition to its poor stock-picking, FXU charges investors above average total annual costs of 0.78%. The slightly higher costs don’t have a huge impact on performance, but investors should not be paying above average fees for an ETF with such poor holdings.

Need For Diligence

Superficially, FXU might look like a good pick. It has a decent dividend yield, it’s been outperforming its benchmark (XLU), and the Utilities sector has been the best performer in 2014. However, a closer look reveals how overvalued FXU is. Combined, its holdings have a price to economic book value (PEBV) of 4.6. In other words, the current market valuation implies that the cash flows of its holdings are going to increase by 460%. That’s a lot of growth baked in. Given that these are low-growth, low-ROIC companies, you have to be quite the gambler to bet Utility companies would exceed these high expectations.

Many Utility companies are following the same pattern as HE and POM, adding on debt every year in order to fund their dividend. In Barron’s feature of my HE report, columnist Vito Racanelli wrote that HE’s investor relations manager when asked to comment on our thesis said that the utility business is capital-intensive and regulated and that many utilities have negative free-cash flow. He would not provide cash flow guidance but offered up EPS estimates. Accounting results can disguise poor cash flows for only so long. Tick tock.

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Disclosure: NewConstructs staff receive no compensation to write about any specific stock, sector, or theme.

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