The Utility Select Sector SPDR has stumbled from a high of $41.44 down into the $30’s, falling 8.5% over the month: sellers were quick to outsell buyers by a 4:1 volume margin over this period. And not surprisingly, the outlook for defensive sectors was glum as economic conditions improved. The last time the sector was out of favour (in relative terms to other sectors) was March, although it didn’t take long to find its feet again. However, in early May I talked about consolidating gains in the utility sector, as it had got ahead of itself. Not surprisingly, when sellers did emerge they were quick to rush to the exits, bringing P/E ratios down to a level where they are again attractive. However, this time around it may be better to accumulate the ETF, rather than go for individual names, which may still be vulnerable to further selling.
Why the ETF?
The key advantage of the ETF is your risk is split across the component 31 stocks. While the top three holdings–Duke Energy Corp (NYSE:DUK), The Southern Company (NYSE:SO) and Dominion Resources, Inc. (NYSE:D)–account for nearly a quarter of the risk, each of these companies has a market cap of over $30 billion each. The overall P/E of the Utility Select Sector SPDR stands at 16, a couple of points above the S&P price-to-earnings ratio, and well off its high of 22 in February. Although price/earning-to-grow ratios of between 2.3 and 3.9 for the aforementioned core three holdings don’t look so attractive when you see that Apple Inc. (NASDAQ:AAPL) has a PEG ratio of just 0.5.
With the sector cast off into the dumpster, the yield has improved to 3.7% (at time of writing), which is attractive, even with inflationary pressures helping bond yields. The drive to cyclicals may backfire if the market decides now is a time to take a lengthy breather 4 years into its rally. But the more pertinent story is how higher lending costs will impact on operations/profits in a highly leveraged sector as utilities: for example, Debt/Equity for Duke Energy Corp (NYSE:DUK), The Southern Company (NYSE:SO), and Dominion Resources, Inc. (NYSE:D) runs at 101, 122 and 198, respectively. Rising rates will hurt the bottom line for these companies. The historic lows for Treasury yields look to be in the past, so the only way would appear to be higher from here.
While signs of economic recovery are great, the economy is not something which turns on a dime. Yes, Treasury yields will rise, but the rate of climb will be slow, and it will take months – if not years – for the effects to filter into the economy. This gives utilities plenty of breathing room before things turn difficult with respect to its leverage exposure.