Summary
- Investors looking for safe havens should think carefully before buying utilities.
- Utility funds are trading near peak price multiples while passive ETFs have been accumulating shares.
- That means some stocks including Aqua America are heavily owned by ETFs, putting them at risk if investors redeem and turn to cash.
It’s official, we’ve reached that point in the market cycle where it’s impossible to ignore articles with titles like “Seven Stocks to Avoid” or “How to Survive the Coming Recession.” We’re not fans of clickbait titles but what really gets under our skin is the fact that almost every one of these articles rehashes some piece of “common wisdom” usually telling you to sell all your tech stocks and hide out with dividend payers like consumer staples or better yet, utilities. Instead we’d argue that whether because of their lofty valuations or exposure to ETF flows, investors need to be just as wary of utility stocks as tech stocks and that they might not offer the protection investors require when the market inevitably turns.
No Discounts for Safety
We know arguing that you need to beware of utilities stocks is a hard sell, even after a great run that has the Utilities Select Sector SPDR ETF (XLU) up over 26% in the last year compared to the S&P 500’s just under 6% return and making them the best performing sector. Best of all, even after their recent run-up, most utility funds are still trading at a discount to their high growth brethren. For all its sideways trading, SPY (standing in for the S&P 500) has a trailing P/E ratio of 19.5X compared to 20.88x for the Technology Select Sector SPDR ETF (XLK) while defensive favorite XLU is all the way back at 17.58x. Some would call that a relative bargain!
And they might be right, but if you look at how richly priced XLU is compared to its own price history, you get a very different picture of the situation. We use historical price multiples to calculate our ETFG Fundamental Quant score, and when it comes to the P/E multiple, XLU is trading at all-time highs relative to its own past. That may sound pretty extreme until you consider that 59 of the 84 public utility stocks are trading at P/E multiples above that of the S&P 500.
Nor is that the only metric showing extreme valuations, XLU’s price-to-book ratio is now in the top 5th percentile, something it has in common with XLK and the growth-oriented segments of the S&P 500. And it’s not the only utility fund trading at high levels, with the iShares U.S. Utilities ETF (IDU) and the Vanguard Utilities ETF (VPU) also trading close to historically high multiples. And the long-anticipated bear market hasn’t even begun yet.
What’s brought utility funds to this level of lofty valuations? There have been serious inflows into utility funds over the last year, with the largest, XLU, taking in over $1.5 billion in new assets while VPU and IDU have seen smaller flows of $700 and $150 million, respectively, but that’s only part of a bigger problem. Of those 84 publicly traded domestic utility companies, maybe 70 of those would meet the normal standards to be included in an ETF index with a combined market cap of over $1 trillion. That’s hardly a narrow range of companies to choose from and combine that with the fact that there are only 10 dedicated utility ETFs with just over $12 billion in assets and it becomes obvious that inflows into utility funds aren’t the only problem.
Instead, we’d argue a much bigger problem is who else are big holders of utility stocks with both the passive index replicators and any number of smart beta funds, including low volatility and high dividend that are natural buyers of utility stocks, making them highly susceptible to fund flows. That combination could mean a lot of trouble for investors, whether they’re buying single stock names or ETFs, who think utilities are an easy answer for troubled times.
