Investing Topics: Investment Strategy

Our bet against utility stocks has continued to pay off, while the selloff in the sector has pulled prices closer to our value-based buy targets. Stay disciplined.

With utility stocks down more than 10 percent since early July, our approach of high-grading the model Portfolios, taking partial profits on overextended names and betting on a pullback has paid off. We weigh the scenarios that could emerge in coming months and revisit our investment strategy.

The investment strategy we’ve pursued over the past several months has paid off thus far. And after the recent pullback in utility stocks, two of our longtime favorites once again trade below our value-based buy targets.

Utility stocks’ summer swoon picked up steam, with the Dow Jones Utilities Average down more than 9 percent from its high in early July. The financial infotainment industry has blamed this pullback on speculation that the Federal Reserve could raise interest rates this fall. In reality, the run-up in utility stocks to record valuations set the stage for momentum-seeking investors to use any excuse as an opportunity to take profits. Expect to hear a lot more about US monetary policy and its implications for utility stocks if this correction deepens in coming weeks. But bear in mind that weakness in the US economy likely will prevent the Federal Reserve from further tightening this year and that market history reveals scant correlation between utility stocks and the direction of interest rates. Consider that when the Federal Reserve hiked the benchmark interest rate by 425 basis points between June 2004 and June 2006, the Dow Jones Utilities Average generated a total return of more than 60 percent—almost four times the gain posted by the S&P 500. Concerns about rising interest rates may give investors an excuse to sell utility stocks in the near term, but frothy valuations not seen since the 1960s will be the real cause. At these levels, momentum-seeking investors tend to have itchy trigger fingers. Against this backdrop, we continue to err on the side of conservatism and bide our time for utility and telecom valuations to revert to the mean, at which point will look to deploy the dry powder we’ve accumulated by exiting riskier positions and taking partial profits on big winners.

The recent selloff in utility stocks has been a boon for our hedge position, but the sector still trades at historically elevated valuations. Investors should stick with our three-part game plan for navigating this challenging market.

The recent spate of equity issuance is yet another sign of frothy valuations in the utility sector, but these moves set the stage for future growth. Investors should bide their time and wait for a pullback to buy our favorite utility stocks.

We share our take on the latest deal flow involving companies in our Utility Report Card, the first earnings of the season and hedging against potential downside in utility stocks.

Eighteen of the holdings in our model Portfolios trade above our value-based buy targets, while several have reached levels where investors should consider taking some of their profits off the table.

Momentum has carried utility stocks to historically high valuations, limiting the number of attractive buying opportunities. Master limited partnerships have also rallied hard from their nadir in February, but stock selection will become increasingly important going forward.

We review our investment strategy in light of our macro outlook and key takeaways from first-quarter earnings.