Issues

With the bull market in its ninth year and equity valuations at historically elevated levels, investors’ growing preference for passive and quantitative strategies seems risky at a time in the cycle when selectivity is critical to success. Giving up this control for lower fees strikes us as a heavy price to pay. Although our favorite utilities proved their worth by maintaining or growing their dividends throughout the Great Recession, these stocks weren’t immune to the gut-wrenching volatility that roiled the market. Weathering the inevitable storms is much easier if you took a little profit off the table when valuations reached unsustainably high levels—a practice we’ve advocated throughout the year. Investors should also remain opportunistic and snap up shares of high-quality companies that temporarily fall out of favor. To this end, we highlight some of our best ideas in the current market. Don’t forget to check out the Utility Report Card for our in-depth analyses of second-quarter results, as well as updated ratings and Quality Grades.

Through the end of the second quarter, more than half the roughly 200 companies covered in our Utility Report Card increased their dividends at least once. Fifteen cut their payouts over this period. About three-quarters of our coverage universe are in the black this year. Lofty valuations on last year’s winners make it much harder for even the strongest names to make significant headway this year—a reason for investors to stay disciplined and stick to our value-based buy targets. The Dow Jones Utility Average historically has struggled to trade at these elevated levels without suffering a reversion to the mean. Whether the benchmark index’s 5 percent decline from its June high marks a real tipping point remains to be seen, though the recent action bears a strong resemblance to the selloff that occurred last summer. Meanwhile, another tipping point for electric utilities has appeared on the horizon: Recent trends suggest that over the coming decade, unsubsidized solar- and wind-power projects will be able to compete on cost with existing coal- and gas-fired power plants. This topic figured prominently at a launch event for Bloomberg New Energy Finance’s recently published energy outlook and at the Energy Information Administration’s annual conference. I attended both and share some of my top takeaways in this issue. Although investors should always view long-term forecasts with skepticism, electric utilities’ investment plans and strategic decisions suggest that the rise of renewable energy could be a real profit driver for the sector, especially when paired with efficiency initiatives.

The Dow Jones Utility Average hit an all-time high this month, raising the bar of expectations to levels that will be difficult to meet, let alone beat. Investors may be in for a bit of déjà vu: The sector last reached these lofty heights in summer 2016, at which point the Dow Jones Utility Average suffered a roughly 15 percent pullback. This correction propelled our position in ProShares UltraShort Utilities (NYSE: SDP)—an exchange-traded fund that’s designed to deliver 2 times the Dow Jones US Utilities Index’s inverse daily return—to a roughly 25 percent profit. Over the past year, these gains have evaporated with the sector’s run-up. But with the Dow Jones Utility Average trading at historically unsustainable valuations, we’re comfortable holding a hedge position that will thrive when the sector inevitably reverts to the mean. Will utility stocks suffer a pullback this summer? The answer depends, to a large extent, on the direction of the US stock market, which has climbed higher while shrugging off political turmoil and middling economic growth. Most of the companies covered in our Utility Report Card will report second-quarter results in late July and early August, creating the potential for company-specific sell-offs. The Federal Reserve’s monetary policy could also give investors an excuse to take profits; however flawed, the conventional wisdom holds that rising interest rates represent a headwind for utility stocks and other dividend-paying equities. Of course, the market can always remain irrational for months—or even years. Although many of our Portfolio holdings trade above our buy targets (a high-quality problem), the market isn’t bereft of opportunities—this issue highlights some of our favorite investment ideas. That said, investors may want to consider taking a partial profit off the table in some of their highest flyers. Better buying opportunities will come again.

This month’s update to the Utility Report Card includes our analysis of first-quarter earnings and guidance for more than 200 essential-service stocks, while the feature article delves into some of the key trends that emerged during this exhaustive process. With utility stocks still trading at elevated valuations, our investment strategy hasn’t changed appreciably; investors should remain disciplined and avoid chasing stocks beyond our value-based buy targets. At the same time, solid first-quarter results underscore the strong fundamentals that should drive above-average earnings and dividend growth for our favorite utility stocks. Sentiment toward utility stocks remains bullish. NextEra Energy’s (NYSE: NEE) share price rallied to a new all-time high, despite the Public Utility Commission of Texas rejecting its proposed purchase of Oncor Electric Delivery—the company’s second deal failure in two years. But high valuations create lofty expectations, increasing the likelihood that investors will view any hiccup, real or imagined, as an excuse to take profits.

After bottoming shortly after the US presidential election, the Dow Jones Utility Average has gained more than 13 percent. This rally has propelled utility valuations to the frothy levels that prevailed last summer, just before the sector sold off in the second half of the year. Investors have plenty of reasons to be optimistic this spring. We expect a strong first-quarter earnings season and, as we pointed out in the November issue, US election results favored telecom sector’s big dogs as well as many gas, electric and water utilities. Utility stocks have also posted strong returns, despite the Federal Reserve’s efforts to normalize monetary policy. The Dow Jones Utility Average has generated a total return of more than 23 percent since the Fed first increased interest rates this cycle, outperforming the S&P 500 by almost 10 points. However, frothy valuations make it difficult for popular utility stocks to generate additional upside. NextEra Energy (NYSE: NEE), for example, appears to have run out of gas now that the stock is in the $130s. And the sub-2 percent yields paid by the highest flyers aren’t much compensation for sticking around in the hope that these stocks will defy the odds and climb higher. A pullback in the broader market remains the most likely catalyst for utility stocks to revert to the mean. High valuations across the board give investors plenty of reason to worry about how much longer this aging bull market can last.  

Shares of utilities and other essential-service companies have slipped from the highs hit earlier this month, reducing the number of Portfolio holdings that trade above our value-based buy targets to 14. Whether this wavering marks the start of another leg down for the Dow Jones Utility Average remains to be seen. However, the recent rally creates a high bar of expectations and increases the risk that investors will view any hiccup as an excuse to take profits. This month’s feature article highlights some of the macro catalysts that could send utility stocks lower. The current environment favors stock-picking over broad-based exposure, a point underscored by the widening discrepancy between the top and bottom performers in the utility sector. Although the Dow Jones Utility Average posted a total return of 18.2 percent last year, the index’s top performer beat the worst by 39 percentage points. This performance gap stands at 20 percentage points this year, despite the Dow Jones Utility Average gaining 5.4 percent. A retrenchment to normal valuations would widen this range. At this point, only 37 stocks tracked in our 205-company Utility Report Card trade below our buy targets. In fact, several dozen best-in-class names that earn A or B Quality Grades in our proprietary system trade at levels where investors should consider taking a partial profit off the table.  

The outlook for interest rates and uncertainties surrounding the Trump administration’s policies likely top most investors’ list of concerns in early 2017. However, investors shouldn’t take their eye off their portfolio holdings’ underlying businesses and future growth prospects. Despite the conventional wisdom that rising interest rates are bad news for utility stocks, the Dow Jones Utility Average has gained more than 20 percent since the Federal Reserve began increasing the benchmark rate in December 2015. These returns reflect the upward drift in the broader market and delivering on guidance for earnings and dividend growth. Strong fourth-quarter results and company-specific developments—not the latest tweet from President Donald Trump—are behind NextEra Energy Partners LP’s (NYSE: NEP) strong returns in the new year. Meanwhile, the recent selloff in Dominion Resources’ (NYSE: D) stock reflects a combination of high expectations and an unexpected revision to the company’s 2017 guidance, not the Federal Reserve’s monetary policy. Nowhere in our coverage universe are hopes higher and easier to dash than in names that traders have bid up as potential takeover targets.

Call it a quadrennial ritual: In the first weeks after the US presidential election, investors scramble to find the trades that will work best under the incoming administration. Invariably, they forget that US government policies are just one of many factors that can influence corporate earnings and investment returns. Eight years ago, the conventional wisdom assumed that the Obama administration would be toxic for the stock market, especially the health care, financial and energy sectors. With only a few weeks left in Obama’s second term, the S&P 500 is up 210 percent, with the health care and financial sectors outperforming. US oil and gas production also reached new heights under Obama’s watch. Conversely, despite rising adoption of renewable energy, Guggenheim Solar (NYSE: TAN)—an exchange-traded fund that offers one-stop exposure to solar-power stocks—burned up almost 80 percent of its value during Obama’s terms in office. Like Obama in 2009, President-elect Donald Trump will take office with his party in control of Congress, creating the potential for the new administration to deliver on promises to cut taxes, reduce regulation and promote infrastructure investment. The past eight years reinforce that Republicans may not accomplish everything they set out to do.

Buying a stock when others are selling can be just as challenging psychologically as taking a profit on an investment that seems to rally every day. However, these incremental moves can help to juice your portfolio’s returns during periods of volatility. Paying close attention to valuation worked well for us in 2016 and will again in 2017, when we’ll learn the extent to which an expansionary fiscal policy can prolong the bull market and accelerate economic growth. This month’s feature article highlights 10 trends that could drive returns for the more than 200 essential-service stocks in our coverage universe.  

The S&P 500 Utilities Index has tumbled in the wake of the 2016 election, as the conventional wisdom holds that the results were bad for utility stocks. Rising interest rates and the prospect of improved economic growth if the Trump administration delivers on its promised fiscal stimulus have given portfolio managers an excuse to rotate out of utility stocks and into cyclical fare. Unsustainably high valuations made this decision all the easier. Conrad’s Utility Investor subscribers who followed our lead over the summer and took partial profits on their big winners and added exposure to ProShares UltraShort Utilities (NYSE: SDP) should be doing reasonably well, all things considered. This exchange-traded fund, which delivers two times the Dow Jones US Utilities Index’s inverse daily performance, has rallied by about 25 percent—and we see the potential for more upside. However, the most important point to take away from this issue of Conrad’s Utility Investor is that the underlying business conditions for our favorite utilities haven’t changed. The sector remains in excellent financial shape and has its best growth prospects in decades. Unfortunately, valuations remain frothy. Election 2016 has created far more opportunity than risks for best-in-class utilities. But potential regulatory tailwinds are only one of the many factors that will drive returns going forward.