Utilities exchange traded funds (ETFs), such as the Utilities Select Sector SPDR (NYSEArca: XLU), usually sport above-average dividend yields and defensive traits that investors seek amid broader market turmoil. However, those characteristics can often make the utilities sector richly valued relative to the broader market.
Investors who are looking for companies to invest in that carry minimal risk will often consider utility stocks. Utility companies typically comprise the most fundamental necessities, such as food, water and shelter, or are closely related to the energy required to refrigerate food, heat up water and light up a house.
The utilities sector is one of this year’s best-performing groups, underscoring the notion that many investors will embrace utilities stocks and exchange traded funds during favorable interest rate environments. It is widely expected the Federal Reserve will not raise interest rates this year and some bond market participants are betting on a rate cut late this year. Fortunately, the sector does not yet appear to be too frothy on valuation.
“The rally in utility stocks has left them trading at 19 times expected earnings, according to the math done by Sophie Karp, KeyBanc utilities and alternative energy analyst,” reports Sophia Cai for Barron’s. “That is 3 turns higher than the 16 times implied by the firm’s analysis of the relationship between the sector and bond yields.”
A Deeper Look at the Perks of XLU
The sector’s highly domestic nature has been an advantage at a time of escalating trade tensions between the U.S. and major trading partners, such as China. Additionally, XLU yields almost 3.10%, well above the dividend yield on the S&P 500 or 10-year Treasury yields.
“So why isn’t Karp worried? Because, historically, utilities have gotten even more expensive late in an economic cycle,” according to Barron’s. “’In the last cycle the disconnect reached as high as 6x,’ she writes. “Consequently, we believe that current elevated valuation levels will prove sticky, as the expectations of the late cycle mount and fund flows increasingly favor defensive sectors such as utilities.”
Investors have pulled almost $485 million from XLU in the second quarter, but the ETF is sporting a quarterly gain of 5.21%.
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