Utilities stocks lose a margin of safety

Big dividend yields and stable businesses: What's not to love about utilities stocks?  The problem is investors love them so much that they're making the stocks a lot more expensive than they were.

The average price-to-earnings ratio of utilities stocks in the broad Standard & Poor's 500 has risen nearly 11% since a year ago, based on a Paste BN analysis of data from S&P Global Market Intelligence from 57 utilities with valid P-E data based on trailing adjusted earnings. The fact investors are paying more for utilities is notable since it's been the largest average increase among all the other 10 sectors. Seven of the 10 sectors – with the exception of utilities, energy and technology – have seen their average P-E fall.

Utilities are known as being "defensive" companies, or those with businesses that hold up no matter how strong or weak the broad economy is. Even in a recession, consumers need to keep the lights on after all. But investors playing defense are pushing up valuations along with the stock prices. The utilities stocks in the analysis have gained an average of 13.4% over the past 12 months, while the average stock is down 2.2% and the Standard & Poor's 500 is down 1.2%. The S&P 500 Utilities index is up nearly 10%, causing some investors to wonder whether investors looking for safety are actually exposing themselves to more risk.

"We see this tremendous bifurcation where defensive equities ... trade at extraordinary valuations compared with the cyclicals in the same markets," Sarah Ketterer, CEO of money manager Causeway Capital said at the Milken Institute Global Conference earlier this month.

Investors aren't going completely overboard being defensive, yet. While utilities' valuations are higher than they were a year ago, they still 20% below the average adjusted P-E of all 10 sectors. Meanwhile, the average stock in another defensive sector, consumer staples, has seen its valuation fall 13%. Investors aren't going hog wild with high-dividend stocks quite yet, either. Shares of the 15 highest yield companies in the S&P 500 are down 28% on average over the past year.

But investors who think they're playing it safe with utilities might be surprised if the market decides the sector isn't worth as much as is being paid for it now, Ketterer says. "For a longer-time horizon investors – we are looking out three years – we have no interest in the defensives."

UTILITIES' VALUATIONS ON THE RISE

Sector, Average P-E now *, % ch. from year ago

Consumer discretionary, 22.6, -15.9%

Consumer staples, 26.1, -12.7%

Energy, 21.6, 3.7%

Financials, 35.4, -1.1%

Healthcare, 38.2, -14.6%

Industrials, 24.0, -9.1%

Information Technology, 37.6, 0.05%

Materials, 23.9, -15.5%

Telecom, 25.2, -5.6%

Utilities, 23.7, 10.8%

* Based on normalized trailing earnings

Source: S&P Global Capital Intelligence, Paste BN