Utilities stocks beat the market. Now they look expensive.

Utilities stocks, a historically defensive sector of the market, have done their job this year, producing a positive total return as the

S&P500

the index fell sharply. Now may be the time to eliminate them.

The

Utilities Select Sector SPDR

the exchange-traded fund (ticker: XLU), which was down 1.5% at $73.87 on Tuesday afternoon, has a positive total return of 5% so far in 2022, compared to a negative return of 18% for the S&P 500. Energy stocks are the only other sector in the black.

Yet utilities now look expensive because of their dividend yields relative to Treasuries and corporate bonds, as well as their price-earnings ratios relative to the S&P 500 index.

The average electric utility dividend yield is now 3.2%, lower than the 3.55% on the 10-year Treasury. Over the past decade, utility dividends have risen by an average of one percentage point relative to the 10-year Treasury, according to a June report from Citigroup that downgraded the sector from neutral to underweight.

The sector’s average price-to-earnings ratio is 21, based on this year’s projected earnings, and around 19.5 on estimated 2023 earnings. By comparison, the S&P 500 is trading at a discount, earning less of 18 times the estimated earnings of 2022 and 16 times the earnings of next year. Based on 2023 earnings, the utilities sector has the same P/E ratio as faster-growing tech stocks.

Other interest rate-sensitive sectors have fared less well than utilities this year, including real estate investment trusts and telecommunications stocks. They can offer better value now.

The Vanguard Real Estate Index ETF, at $88, has returned negative 22% so far in 2022 and returned 3.2%.

Verizon Communications

(VZ), which hit a 10-year low on Tuesday, ended at $40.59 and is up over 6%. Verizon stock has posted a negative 18% return this year, while

AT&T

(T), at $16.56, posted a negative return of 6% in 2022 and a return of 6.6%.

One utility skeptic is Chris Davis, president and portfolio manager at Davis Select Advisors, which manages the Davis New York Venture Fund (NYVTX).

“I’m still baffled by why utilities with high payout (dividend) ratios trade at the multiples they do against things like banks,” he said. “I think the dividend outlook for banks over a longer period will be much more favourable,” Davis said in a statement. Barrons podcast on Monday. Bank stocks are down an average of almost 20% this year and many are yielding 3.5% or more.

Electric utilities like

duke energy

(DUK),

South Co
.

(SO), and

Consolidated Edison

(ED) tend to have dividend payout ratios of 65% or higher. Bank payout ratios (annual dividends divided by projected 2022 earnings per share) are typically below 40%. Banks have similar returns to utilities, but their P/E ratios are closer to 10 than 20.

Davis said an unappreciated risk for regulated electric utilities is whether companies can get approval for rate increases to offset rising costs.

“Utility investors haven’t had a long environment of rising costs — you’ve had 20 to 30 years of falling costs,” Davis said. “Running a regulated business when costs are falling and therefore not having to pass on price increases is easier than going to regulators and saying, ‘let the prices go up’.”

Another risk with utility stocks is that they may fall to reflect higher bond yields, making their dividends less attractive compared to what investors can get from low-risk government debt, not to mention the declines in other sectors sensitive to stock market rates.

So why do utilities trade well? A favorable outlook and positive fund flows could be the answer. The $18 billion Utilities Select Sector SPDR ETF saw about $5 billion in positive net flows in 2022.

“The industry has been at its best for 10 or 15 years,” says John Bartlett, president of Reaves Asset Management, which manages Reaves Utility Income (UTG), a closed-end fund that currently trades around $31. dollars per share.

It may surprise many investors that supposedly stodgy utilities have beaten the S&P 500 for the past 20 years. The SPDR Utilities Select Sector ETF has average annual returns of 11%, compared to 10% for the S&P 500. And over the past decade, utilities have been just one percentage point behind the index, with annual returns of 11.2% versus 12.3% for the S&P 500. .

Over the next decade, utilities will invest heavily in renewable energy by shifting away from coal and, to a lesser extent, natural gas, and building transmission lines. This growth is expected to fuel the growth in average earnings for singles in most utilities. Combine that with 3% returns and investors could generate high single-digit annual total returns, with low volatility, Bartlett says. Dividend growth could average around 5% per year.

It favors the industry leader

NextEra Energy

(NEE), which owns well-run utility Florida Power & Light and the nation’s largest portfolio of renewable energy assets. NextEra stock, at around $85, returns 2%, below the industry average on stronger earnings growth prospects. NextEra is trading at 30 times projected earnings this year, a premium for the group. Bartlett sees potential for increases in the company’s earnings estimates for 2023 and 2024.

Bartlett also likes

Public Service Enterprise Group

(PEG), which is trading around $65, or about 19 times expected earnings per share for 2022, with a yield of 3.2%. He says the stock price has been hit this year by the impact of a weaker stock market on the company’s retirement assets. Bartlett says the New Jersey-based company is participating in an attractive offshore wind project in the Atlantic Ocean.

Bartlett is less enamored with New York-based Con Ed, whose $97 stock is up about 14% this year. Con Ed is trading at 22 times forecast 2022 earnings and yielding 3.3%.

Write to Andrew Bary at [email protected]

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