Whatever you think about utilities, you’re probably wrong.
One current narrative about the sector, for example, has it that after years of being more conservative than the broad stock market, utilities suddenly have become riskier. As illustrated by the recent bankruptcy filing of PG&E PCG, +0.71% , California’s largest utility, utilities no longer seem to be the boring stocks paying regular dividends that are appropriate only for widows and orphans.
Or so the story goes. Yet this narrative is not helpful. In some respects, in fact, it appears to be just plain wrong.
Consider what I found when comparing the volatility of the utility sector (as represented by the Utilities Select Sector SPDR XLU, -0.04% with that of the S&P 500 SPX, +0.00% (as represented by the S&P 500 Select Sector SPDR SPY, +0.01% ). At least when measuring volatility on the basis of the standard deviation of monthly returns over the trailing 24 months, the sector’s volatility has been trending downward for several years and is now, for the first time in over five years, lower than that of the broad market. (See chart.)
The picture painted by this chart is therefore just the opposite of this newly-emerging narrative. The sector actually became more volatile than the broad market starting in 2013 and is now reverting to historical form.
What can we learn from this? Perhaps the most obvious lesson is the importance of subjecting our hunches to statistical scrutiny. This is good advice to follow in all aspects of our lives, of course, but especially in the investing arena, since brokers have an incentive to concoct “just-so” stories that will induce their clients to buy or sell and thereby generate commission income.
This isn’t to say that the utility industry isn’t going through many changes. But those changes are probably better thought of as evolutionary rather than revolutionary.
For example, according to Dow Theory Forecasts, non-regulated operations are only slowly growing as a share of revenue in the utility sector. According to the newsletter, that share grew by just 4.2 percentage points between 2014 and 2017 — from 30.6% to 34.8%. (By non-regulated operations, Dow Theory Forecasts has in mind businesses such as banks and construction.)
The realization that utilities are gradually diversifying into non-traditional operations leads to yet another investment lesson: It’s important to be clear about the investment rationale underlying your investment approach. Are you investing in utilities because you like their business model? Or are you doing so because you believe that utility stocks are more conservative and less volatile than the overall market?
That’s a good question, because if your rationale is this latter one then you should focus directly on investing in low volatility stocks rather than in utilities, whose stocks may or may not be as placid as you think.
One investment option for investing directly in low volatility stocks is the iShares Edge MSCI Minimum Volatility USA ETF USMV, +0.00% which is benchmarked to an index comprised of low volatility stocks. Despite a beta of just 0.75, it has beaten the S&P 500 over the last five years by 1.5 annualized percentage points. Beating the market with below-market risk is a winning combination, of course.
It’s also worth pointing out that low volatility stocks, as represented by USMV, beat the utility sector by 1.6 annualized percentage points over the last five years (as measured by the iShares U.S. Utilities ETF IDU, -0.08% .
What if your investment rationale for holding utility stocks is receiving a steady stream of dividend income? In that case, you need to be choosy, as shown by PG&E’s demise.
The investment newsletter I monitor with the best record when approaching utilities and other dividend-yielding stocks is Investment Quality Trends. The newsletter is in first place for risk-adjusted performance over the last 30 years, according to Hulbert Financial Digest monitoring.
Editor Kelley Wright requires a dividend-paying company to jump over several high hurdles before he will even consider whether its yield is attractive. Those hurdles are designed to insure that a company is in sound-enough financial condition to continue paying its dividend even in bad times. These hurdles are:
- Dividend increases 5 times in the last 12 years
- S&P Quality Ranking in the “A” category
- At least 5,000,000 shares outstanding
- At least 80 institutional investors
- At least 25 years of uninterrupted dividends
- Earnings improved in at least 7 of the last 12 years
Pacific Gas & Electric, you’ll be interested to know, dropped off of Wright’s watch list almost 20 years ago, when the company first suspended its dividend. (The company reinstated its dividend in 2005, before cutting it again more recently still.) So, with decades to spare, a follower of Investment Quality Trends would not have been owning the company’s stock when it recently fell into bankruptcy.
Once a company makes it onto his watch list, Wright deems it undervalued if its dividend yield is close to the high end of its historical range. Currently, just one utility satisfies that requirement: Consolidated Water Co. CWCO, +0.15% , with a dividend yield of 2.6%.
Wright, in an interview, said we shouldn’t be surprised that there are so few truly undervalued utility stocks right now. He pointed out that the sector itself — as represented by the Dow Jones Utility Average DJU, +0.13% — sports a dividend yield that is close to the low end of its historical range. That’s a sure signal in Wright’s world that something is overvalued.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .