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Opus News & Insights

Can Utilities Keep Going at Max Power?
Wednesday, July 13, 2016

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Owners of utilities, like Springfield’s C. Montgomery Burns, have certainly had excellent returns lately. Through June 30, the sector was up almost 23% for the year (at least within the Russell 2000 Value Index), and is on pace for its third consecutive year of outperformance. The YTD gains in the sector in the S&P 500 are the best to start a year since at least 1990 according to research by EACM.

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However, there is increasing concern of a, gasp, bubble in the sector, with the Wall Street Journal, the always rational talking heads at CNBC, and Market Watch expressing concern. Famed investor Jeff Gundlach cited shorting utilities as part of a pair trade during his presentation at the Ira Sohn conference in May. As we see from the following graphs, both large cap utilities (Graph 1) and small cap utilities (Graph 2) are over one standard deviation above their five-year average trailing P/Es.

Graph 1

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Graph 2

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This surge (pun intended) in utilities differs from past episodes of speculation in that the desire is almost exclusively for yield (and safety, to some degree) as opposed to rampant speculation in hopes of massive capital appreciation, e.g., internet stocks in the late 1990s or housing in the mid 2000s. One need only look to this correlation between 10-year utilities and U.S. Treasury yields for evidence:

Utilities v. 10-Year Treasuries

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However, when viewing valuation from the perspective of dividend yield versus US Treasuries, one could make the case that the sector is inexpensive versus history. Within the context of dividend yield versus global bond yields, the case is more compelling, given rates on the US 10-year are exceeded only by those of Portugal and Australia.

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What does Opus think of utilities? As process-driven, bottom-up investors, we look at each company we evaluate individually. Currently, we are seeing few, if any, utilities that are cheap enough to satisfy the valuation component of our investment process. They certainly look expensive versus their own history, whether you look at trailing P/Es, as we saw in Graphs 1 and 2, or forward P/Es (Graph 3), where we see a forward multiple of 19x versus their historical average of approximately 14x. Accordingly, we have recently been net sellers in the sector, and are underweight in both of our small cap strategies:

Graph 3

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However, we acknowledge that a credible case can be made that, given global rates, utilities may not be as overvalued as they appear on the surface. Additionally, with expectations for global growth anemic at best, perhaps the modest single-digit growth offered in this highly regulated sector is better than the less certain earnings growth, or potential decline, found in other sectors. If utilities truly are the best growers in a no growth world, it is hard to envision the Fed raising rates in this scenario. Ultimately, it seems that the fate of utilities will be determined almost exclusively by interest rates. If rates increase, investors face a situation much like Homer’s nemesis, Frank Grimes.

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If rates decrease from current low levels, utility investors would likely be happier than a billionaire with a gorilla vest, regardless of current stretched valuations.

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