Utilities Investors May Need to Ponder How Much They're Willing To Pay For Yield

Aided by three interest rate cuts by the Federal Reserve and various periods of investors leaning toward defensive assets, the Utilities Select Sector SPDR XLU, the largest utilities exchange traded fund, is higher by 19.56% year to date.

While that trails the S&P 500, the utilities sector has lived up to its reputation of being less volatile and delivering higher dividend yields. XLU's yield of 2.92% is about 100 basis points higher than the S&P 500's.

Historically, the trade off for paying defense with low beta sectors with above-average dividend yields has been valuations in excess of the broader market's. That concern is again relevant for investors considering XLU and rival utilities ETFs.

Why It's Important

“Utilities are a sector that investors often turn toward for yield, but we also think that investors should be cognizant of valuations,” Morningstar said in a recent note. “Right now on the yield front, when you look at 10-year U.S. Treasuries below 2% and the U.S. dividend yield for utilities above 3%, utilities look like an attractive yield option.”

The $11.13 billion XLU tracks the Utilities Select Sector Index, which sports a price-to-earnings ratio of 23.80x, according to issuer data.

“However, valuations are extremely rich. Price/earnings multiples, price/book multiples are all well above three-year decade averages,” according to Morningstar. “Even we think the sector is well overvalued. Although it started the year at fairly valued, we think utilities are now 13% overvalued given the run that they've had in 2019.”

What's Next

There is some evidence investors are taking profits in utilities stocks and shifting to riskier sectors. XLU has shed $170.11 million in assets in the fourth quarter. On the other hand, investors don't need to run from utilities ETFs simply because of valuations.

“The industry has very good balance sheet strength, fair payout ratios, and a lot of good growth," Morningstar said. “A couple of names we like are those yielding above 4%, such as CenterPoint, Duke Energy, Edison International, and Dominion Energy. We think these utilities are well positioned to grow earnings and dividends based on the infrastructure investment needs across the U.S.”

Duke Energy DUK and Dominion Energy D combine for 15.6% of XLU's weight.

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