5 utility stocks doomed to underperform
Chasing yield? Well, beware of these overvalued utilities.
Utility 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.
- For you yield chasers: Sean Williams has the other side of the trade with 3 utilities to buy. (The Motley Fool)
- Of course … he follows that up with these 3 utilities to sell. (The Motley Fool)
- Do oil prices portend a move for utilities? Chris Vermeulen says utilities look bullish in 2013. (Minyanville)
- Adam Johnson warns in this video that utility stocks may have run out of gas. (Bloomberg TV)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org 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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