Breaking Down Utilities (XLU)

July 29, 2014 8:25 AM

After yesterday’s 1.4% advance, the utilities sector once again took the lead as the best performing major sector in the U.S. market in 2014.  I discussed the technical situation in last month’s MorningWord, when the Dow Jones Utility Index broke out to a new all-time high:

Dow Jones Utility Index monthly chart, Courtesy of BloombergDow Jones Utility Index monthly chart, Courtesy of Bloomberg

As part of the back and forth action in the utilities sector in the past few months, both implied and realized volatility have gradually inched higher as options traders re-priced the market after the breakout:

30 day implied volatility in blue, 10 day realized volatility in white, Courtesy of Bloomberg30 day implied volatility in blue, 10 day realized volatility in white, Courtesy of Bloomberg

While most assets have implied volatility near multiyear lows, the utility sector is an outlier in that options prices are near the middle of the 2 year range.

Given the outperformance in the sector and the technical situation, I wanted to take a brief look at the largest stocks in the sector.  The 5 largest components are DUK, NEE, D, SO, and EXC.

Those 5 components should be considered in two separate groups. NEE, D, and SO are the three growth stocks, where EPS is 40-100% higher over the past 10 years, and the stocks’ valuation on a Price/Book basis is between 1.75 and 3.50.  On the other end are DUK and EXC, which are the cigar butts of the group.  EXC annual EPS has actually contracted over the past 10 years (and has been very volatile in the process), while DUK EPS is up about 20% in the past decade.  EXC and DUK both have a P/B ratio in the 1.2 to 1.3 range.

Some of the relative strength or weakness among the utilities can be attributed to geographic disparity.  NEE is based in Florida, a major growth market, and has benefitted from a higher growth in demand than utilities in other areas.  SO is headquartered in Georgia, and Dominion is in Virginia and North Carolina.  All 4 of those states have had above average population growth over the past 5 years (see the list of population growth by state).  Meanwhile, Excelon operates primarily in Illinois and Pennsylvania, where the population has hardly grown.  Duke is based in North Carolina as well, though its operations are more diversified.

In terms of management prowess, NEE looks like the standout of the group, as EPS has grown in each year since 2005.  Moreover, the company is making a strong push in wind and solar power plants in the U.S.  Though the renewables segments are still a small part of the overall business, the long-term prospects look encouraging.

However, valuation for the growth stocks, NEE, D, and SO, is significantly higher than EXC and DUK, and also quite a bit higher than the historical valuation of NEE, D, and SO.  That is of course an indication of the conducive market backdrop over the past few years, and the search for yield that has led so many investors to the utilities sector.

At this juncture, I’d still rather buy the consistent performers, like NEE and SO, and possibly hedge some of the risk of a breakdown in the utilities sector as a whole with farther dated XLU puts.

This post by Enis Taner (@enistaner) originally appeared on RiskReversal.com

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