Market Overview

Danger Zone: Utility Sector Funds

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Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Utility sector ETFs and mutual funds are in the Danger Zone this week. The Utility sector edged out the Financials sector to rank last among all ten sectors in my 4Q13 Sector Rankings report.

Of the 41 Utility ETFs and mutual funds under our coverage, 40 earn a Dangerous-or-worse rating. The best rated Utilities fund gets my Neutral rating, but it is a stretch to call it a Utilities fund. It is American Century Quantitative Equity Funds: Utilities Fund (MUTF:BULIX) and its top three holdings are Telecom stocks: AT&T (NYSE: T), Verizon (NYSE: VZ), and Century Link (NYSE: CTL).

Figure 1 shows the breakdown of our ratings on stocks, mutual funds, and ETFs in the Utility sector. 50 out of the 139 stocks (or 35% of the market cap of the sector) held by Utility funds earn a Neutral-or-better rating. The rest are Dangerous or worse. Note, in Figure 1 below, “TNA” stands for total net assets.

Figure 1: Utility Sector Landscape For ETFs, Mutual Funds & Stocks

DangerZone_UtilitySector_2013-10-07Sources: New Constructs, LLC and company filings

Investors are doing a decent job of putting their money in the slightly better funds in the Utility sector as the majority of capital (i.e. TNA) is in Dangerous-rated funds instead of Very Dangerous-rate funds. Still, the pickings are slim for good funds. Investors should have access to more funds with an Attractive-or-better rating.

Financials took home last place in our third quarter sector rankings, but it beats Utilities this quarter. Financials offers 26 Neutral-rated ETFs and mutual funds for investors compared to just one for the Utilities sector. I rate both sectors as Dangerous, but at least investors in the Financials sector have a few more Neutral options.

The poor holdings in Utilities funds cannot be blamed entirely on ETF providers and fund managers. Figure 1 shows that there are not many Attractive Utility stocks to choose from. However, there are enough Neutral-or-better rated stocks to justify more than just one fund with a Neutral rating. Mutual Fund managers and ETF providers have better stocks to put money in. They are just not choosing to do so, which begs the question of whether or not they deserve their fees.

The primary problem with Utilities stocks is they are overpriced. Many investors are seeking dividend yield without regard to the underlying fundamentals of the stocks. So they push the prices of these stocks well beyond levels that the fundamentals can justify. I commented on this same phenomenon when I putREITs in the Danger Zone a few months ago. Investors need to look beyond dividend yield strategies and recognize the variety of ways companies can create value for shareholders.

Viacom (NASDAQ: VIAB) is a good example of a company that has created value for shareholders despite a small (1.5%) dividend yield. As I highlighted in my article last November, VIAB has undertaken an impressive stock buyback program over the past few years that has offered a nearly 15% yield to investors. In August of this year, VIAB doubled that buyback plan and is returning $20 billion to investors. On the strength of these buybacks and strong profits, VIAB is up 65% since my article. Even still, the stock keeps my Attractive rating. At ~$82/share, VIAB has a price to economic book value ratio of only 1.4, which implies only 40% profit (NOPAT) growth for the remainder of its corporate life. VIAB has grown NOPAT by 13% compounded annually over the past six years, so it should easily surpass those modest expectations.

I would much rather own a low dividend yield stock with solid fundamentals like VIAB than a high-yield stock that has a shaky foundation. For instance, Piedmont Natural Gas (NYSE: PNY) has a dividend yield of 3.9%. However, a close look at the company’s filings shows that the stock is dangerously overvalued. PNY has almost no NOPAT growth over the pas six years, and its return on invested capital (ROIC) has steadily declined from 6% to 4% in the last decade. PNY has earned negative economic profits in every year going back to at least 1998. Despite its operational struggles, PNY has a significant amount of growth baked into its stock price. PNY’s current valuation of ~$32/share implies 7% NOPAT growth compounded annually for 16 years. Failure to meet those growth expectations could result in capital depreciation for PNY shareholders at a much larger clip than the 3.9% dividend yield. Even if the dividend remains, investors in PNY could lose a significant amount of money.

It seems like every day I see an ad for a new dividend or ultra-dividend ETF. Investors need to realize that dividend ≠ safe. Successful investing requires real diligence. Just buying high dividend yield stocks, or trusting an ETF provider or mutual fund manager to pick the right stocks, is not the best way to earn high returns. Investors tempted by the high yields of Utilities funds need to dig deeper to see the risk within.

Sam McBride contributed to this article

Disclosure: David Trainer owns VIAB. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

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