HH Are Utilities In A Bubble?

UtilitiesBubble_featureimage

Utilities are on a tear. Without accounting for dividends, the Utilities Select Sector SPDR ETF (XLU) is up 17% so far in 2016 and 28% over the past three years, in both cases outperforming the S&P 500 (SPY). Stocks that are supposed to be safe income plays have delivered major capital gains.

It’s not hard to figure out why this is happening. Interest rates have been at historic lows for several years now. As the Fed continues to push back its timetable for raising rates, bond investors are capitulating and turning to Utilities as a source of yield.

This run-up has many people uttering an unusual phrase: “Utilities Bubble”. Could these traditionally safe stocks be dangerously overvalued and setting up for a crash? And if so, how should investors manage their portfolios to mitigate this risk?

Utilities’ Profits Do Not Justify The Stock Performance

Let’s quickly dispense with one possible counterargument: that the strong run for Utilities stocks is based on improved financial performance and not yield-chasing investors. Figure 1, which shows the trends in average return on invested capital (ROIC) and cumulative after-tax operating profit (NOPAT) for the sector over the past few years, clearly shows that profits are flat to down and not driving stock valuations higher.

Figure 1: Utilities ROIC And NOPAT

NewConstructs_UtilitiesProfitabilityDeclining_2016-08-10

 

Sources: New Constructs, LLC and company filings.

Nor do macro industry trends support hope for growth in future cash flows. In fact, the exact opposite is true.

  • Solar panel installations are projected to grow by 119% in 2016.
  • The market for energy efficient LED lighting is growing at 45% annually, part of a larger move towards greater energy efficiency in US households.
  • With shrinking demand, Utilities will be forced to raise rates on remaining customers, leading to an even higher adoption of solar power and energy-saving devices. According to Barron’s, half of electric-utility executives expect these trends to send their industry into a “death spiral” within the next decade.
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Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or ...

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David Zarling 4 years ago Contributor's comment

This was a great article. Utilities may be lagging it sounds like. Take a look at this tweet to see what I mean: twitter.com/360research/status/761624145650192385

Carol Klein 4 years ago Member's comment

Absolutely right.