These Stocks Won't Stay Cheap Forever
The Most Undervalued Utility Stocks
High Dividend Utility Stock #2
Utility stocks are known for being low risk-they're often called "widow and orphan stocks" because they're appropriate for just about any investor. Utilities deliver slow but steady growth, and take advantage of that predictability to pass much of their cash through to investors as regular dividends. The average utility stock yields about 3%, while the S&P 500 yields just 1.9%.
But late last year, dividend-paying utility stocks started acting less like slow-and-steady tortoises, and more like sprinting hares. In the last three months of 2014 and the first month of 2015-from October 1 to January 30-the Utilities SPDR (XLU) advanced 15%, while the S&P 500 gained only 1%.
Unsurprisingly for investors who know the story of the tortoise and the hare, utilities have now fallen back to earth, crashing 6% in February alone. In the meantime, the S&P 500 rose 5%, to ultimately outpace the XLU over the past five months. Here is a chart of XLU's rapid advance-and its equally rapid downfall-since October 1, 2014. Compare it to the S&P's action in orange:
While this amount of volatility is highly unusual for utilities, it's far from unexplained. As we approached the end of 2014, utility stocks were benefiting from a "perfect storm" of macro factors. Energy prices were falling to multi-year lows, reducing utilities' input costs. The U.S. dollar was moving in the other direction, hitting multi-year highs against most foreign currencies. Combined with weak growth from some international economies, the strong dollar made international stocks and multi-national companies that earn a lot of their revenues overseas much less attractive-while making U.S. utility stocks, whose revenues are usually entirely domestic, much more appealing.
Also driving investors into utilities was treasury bonds' slide to multi-year lows. Investors and institutions that rely on fixed income investments to generate yield were forced to look elsewhere for regular income, and high yield utility stocks were an appealing alternative. Utility stocks that pay dividends yield more than 3% on average, and many yield 5% or more. And safe-and-steady utility stocks are perceived to offer about as close as you can get to bond-like behavior while staying in the equity markets.
Lastly, low oil prices were raising fears that small energy companies would begin defaulting on their debt in large numbers, which could disrupt through the junk bond market. That also made utility stocks more attractive, since most utilities are investment-grade borrowers and are considered safe.
So, what's changed? For one thing, interest rates rebounded sharply as February began, thanks to a strong jobs report that showed some wage growth-a prerequisite for inflation. That accelerated the expected timeline for the Fed's next interest rate hike, causing yields on existing treasuries to rise. You can see how the sudden rebound in the 10-year treasury rate (orange line) corresponds to the end of the five-month rally in the Utility SPDR (blue line) on the chart below:
In addition, while oil prices are still very low, they stopped falling at the end of January and have begun recovering in recent weeks. They're not high enough to make utilities less attractive on a fundamental basis-input costs will still be very low-but the risk of a collapse in the junk bond market has lessened, at least in investors' minds.
And while the dollar is still very strong, it has remained at about the same level since early February (its first month without a big advance since June).
Also likely playing a part is the broad stock market's strength: the major indexes all advanced strongly in February, drawing investors back into more aggressive, "growthier" stocks. Boring old utility dividend stocks have been left by the wayside.
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The Most Undervalued U.S. Utilities
But that's fine with us income investors! While we took advantage of and enjoyed utilities' moment in the sun (in my premium advisory, Cabot Dividend Investor, we booked a 29%, 12-month gain on part of our ConEd position earlier this month), we were never in these stocks to make a quick buck. In fact, utility stocks are more attractive now that they've fallen back to earth: their yields are higher and their valuations lower.
Currently, the average P/E for utility companies is about 23. Based on P/E ratios, the most undervalued U.S. utilities today are:
Edison International (EIX), which is, despite its name, Southern California's electric utility. It has a P/E of 15.
Public Service Enterprise Group (PEG), a New Jersey-based electric utility with a P/E of 14.
PPL Corp. (PPL), an electric and gas utility that operates in both the U.S. and U.K., also has a P/E of 14.
New Jersey Resources Corp (NJR), which is part natural gas utility and part energy company, has a rock-bottom P/E of 10. The energy operations make this a higher risk play right now.
But the second-lowest P/E ratio in the group, at 13, belongs to SJW Corp. (SJW), a water utility serving California and Texas.
For bargain hunters, SJW Corp. is my favorite undervalued utility to buy today. The stock has lagged both the broad market and its peers for the past five years, and has the second-lowest P/E in the group. However, SJW earns a Dividend Safety Rating of 9 out of 10 and a Dividend Growth Rating of 7 out of 10 from IRIS, my proprietary dividend stock rating system. The company has paid dividends since 1968 and increases the dividend a little bit every year. Currently, SJW pays an annual dividend of 78 cents for a yield of 2.4%. The company's payout ratio is lower than average at around 30%.
SJW is facing some challenges, including a drought in its California service area. In addition, the company's financials appear uneven-and comps will be difficult-because of a retroactive rate increase approval that was booked in the third quarter of last year. But for long-term investors with tolerance for short-term volatility, SJW is an attractive value.
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Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor