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.
If this bull market has more room to run, stocks that have sat on the sidelines for one reason or another offer the best valuations and upside potential. In this issue, we sift through the smaller-capitalization companies covered in our Utility Report Card for potential bargains.
With 20 of our Portfolio holdings trading above our value-based buy targets, investors must remain disciplined and resist the urge to overpay for our favorites.
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