5 utility stocks doomed to underperform

Chasing yield? Well, beware of these overvalued utilities.

By InvestorPlace Feb 7, 2013 3:06PM
Electricity pylons copyright Digital Vision., Photodisc, Getty ImagesBy Jeff Reeves

iplogoUtility stocks were the fashionable trade of 2011, with the broad-based Utilities Select Sector SPDR (XLU) racking up 14% gains vs. a down market. 

In 2012, however, utility stocks underperformed significantly, with the XLU fund posting a small loss in the calendar year vs. double-digit gain for the S&P 500.

So are utility stocks back in favor this year? 

You might think so given the only modest underperformance in January -- the XLU is up 4.3% year to date vs. 5.9% for the S&P.

Unfortunately, the sector is grossly overvalued as a whole. According to WSJ Market Data, the Dow's Utility Index is running hot at a trailing 12-month price-to-earnings ratio of 22.2 -- up dramatically from 14.4 at this time last year.

You might quibble over whether the market in general commands a higher P/E right now based on macro issues or whether individual stocks like Amazon.com (AMZN) still can be a good investment at nosebleed valuations. However, utilities are inherently low-growth stocks with modest historical P/E's, and there’s no excuse for this kind of premium.

Many things go into stock selection, and I don't mean to discount the long-term potential of these stocks -- particularly if you have a good cost basis and a robust dividend yield. But these specific picks in the utility sector should be setting off warning bells based on their overpriced valuations:

Southern Company (SO) has a modest trailing P/E of 16.2 and a forward P/E just south of 15 right now, but more importantly, it boasts an inflated five-year PEG ratio of 3.3 thanks to a mere 2% in projected earnings growth for fiscal 2013. The company also trades for twice its book value. The most recent analyst rating on the stock is a "hold" from Deutsche Bank on Jan. 31 with a $45 target -- a measly 3% upside from here -- which was reduced from a previous target of $46 that was only slightly less disappointing. Barclays had a similar message on Jan. 31 with an "equal weight" recommendation, reducing its price target from $48 to $46.

Consolidated Edison (ED) has a reasonable trailing and forward P/E, with both figures around 14.8. However, it has a five-year PEG ratio of 6.2 that seems way too rich for a utility. The company just missed earnings forecasts, reports rttnews, on declining revenue to boot, prompting UBS to cut the utility stock to "sell."

Duke Energy (DUK) has been making headlines with a report that it will close a troubled nuclear plant, possibly passing on some $1.65 billion in costs, according to USA Today. But more important to investors is a whopping five-year PEG ratio of 5.4, trailing P/E of 22.7 and forward P/E of 15.8. Duke shares have been outperforming year to date in 2013; however, the mean price target is in the $69 range ... right where the stock is currently. There isn't much more upside here, based on the data.

Dominion Resources (D) has a mammoth 26.6 trailing P/E ratio, but a more modest forward P/E of 15.2. The five-year PEG ratio of this utility stock is 2.2. And for what it's worth, equity analysts at Standard & Poor's project the stock is overvalued almost 20% based on their proprietary quantitative model. Sure, S&P doesn't exactly have a stellar reputation ... (see InvestorPlace.com) … but Barclays just piled on, too, with an "underweight" recommendation on Feb. 1.

NRG Energy (NRG) had a tough row to hoe in 2011 and early 2012, marked by some ugly quarterly losses and a rocky conclusion to its $1.7 billion merger with GenOn to form the largest independent power producer in the U.S. But optimism picked up around mid-year and shares are currently up 60% from their July lows. This might be too much too fast, with NRG now boasting a forward P/E of over 38, and fiscal 2013 forecasts indicating just 3% revenue growth and flat earnings. The GenOn deal could deliver long-term efficiencies down the road, but there's a risk that those gains have already been priced in and that investors don't have much upside from here.

One final note: I am not saying utility stocks are categorically a "sell." If you're dabbling in utility stocks based on previous long-term buys, with a much lower entry point and an attractive dividend yield on your cost, you might well see 5% to 10% gains annually across the next few years.

But keep in mind that new money is jumping into a crowded trade with some pretty rich valuations. If there's a sector you're looking to invest fresh capital in right now, I would strongly advise looking elsewhere.

Related reading

Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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