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Are utility funds too hot to handle?
Funds that specialize in power-company stocks posted 20%-plus gains in 2003 and 2004, and they're jumping again this year. That makes them tempting but pricey.
By Timothy Middleton
Credit low interest rates with another asset bubble -- in utility stocks.
This least-glamorous corner of the stock market is also the second-hottest, after energy. The average mutual fund investing in power-company shares shot up more than 20% in each of the last two years and was ahead 11.0% this year, as of July 5. The market is marginally lower this year and is ahead only about 8% per annum in the same period.
With that surge, utility stocks are now trading at prices that average 15.7 times estimates of next year's earnings. That is equal to the market's price-to-earnings multiple. Historically, utilities have traded at 70% of the market multiple.
Said a different way: Utilities are half-again as risky now as they were 30 months ago.
"I'm really struggling, frankly, to find some relative values," says Maura Shaughnessy, who has managed MFS Utilities Fund (MMUFX) for more than 13 years. "I always try to buy good managements cheap, and good managements aren't cheap right now."
The fact that investors aren't as worried about a bubble in utilities as in housing is probably because they're unaware of it. The entire utility sector represents fewer assets than scores of individual diversified mutual funds. But as surely as carts follow horses, investors line up behind whatever is hot.
So I recommend you amaze your friends by being the only one who is not buying a utility fund this summer. I also recommend not trying to jump the Grand Canyon on a motorcycle -- for the same reason: Success is too unlikely.
The Buffett seal of approval
The bulls have strong arguments in favor of utility stocks. Company fundamentals are improving after Enron's blow-out. Yields, which average 3.4%, are mouth-watering. Merger activity is accelerating, a sure sign that knowledgeable acquirers think their targets are cheap. Best of all, Warren Buffett likes utilities.
The world's smartest investor is in the process of acquiring PacifiCorp from Britain's Scottish Power (SPI, news, msgs). Together with utilities he already owns, the acquisition would create an electric and natural-gas power company with 3 million customers in 10 states.
Related news and commentary on MSN Money
Buffett has said he expects his holding company, Berkshire Hathaway (BRK.A, news, msgs), to continue making utility acquisitions for 10 to 20 years.
In other mergers, Public Service Enterprise Group (PEG, news, msgs) is in a deal to acquire Exelon (EXC, news, msgs). The former is known as PSE&G. The latter does business as Commonwealth Edison and PECO Energy.
"Now you've got a group of municipalities trying to buy NorthWestern (NWEC, news, msgs) in Montana, so you even have a hostile takeover, which is unheard of in this industry," says Shaughnessy.
The sector's yield, which is twice the market average, is very safe, says Matthew Smith, co-manager of the Franklin Utilities Fund (FKUTX, news, msgs). "We see room for growth," he says. "Utilities are only paying out 63% of their earnings as dividends. Traditionally, that has reached into the 80% to 90% area."
Smith notes that utilities are among the most defensive of stocks. And the market cherishes defense during times of uncertainty, such as now.
A sector ignoring its bad news
But popular stocks always have a good story -- that's why they're popular. The bearish argument is powerful, too. It takes two tacks.- All this good news is fully priced into the stocks. Result: They are far more expensive than they usually are. If the market decided utility stocks were worth 25% less, they'd still be more costly than they usually are.
- The second argument has to do with interest rates. The Federal Reserve has raised them nine times in 54 weeks. By all that's right, that should kill a rally in utility stocks dead, dead, dead.
Utilities are very capital intensive. So, any increase in the cost of borrowing hits them like a pile driver. Also, utility stocks compete for investors' attention against high-quality bonds. If the rate on the 10-year Treasury went up one percentage point, the value of the bonds would decline 10%. Prices of utility stocks also would have to fall to boost their dividend yields commensurately.
Interest rates, of course, are in a mysterious twist. While short rates have risen more than 200%, long rates have actually declined somewhat, to Monday's 4.13% on the 10-year Treasury from 4.25%. Bill Gross, the savviest interpreter of rates in the industry, says that's because inflationary expectations have evaporated.
But the reason energy is the hottest sector right now is that oil prices have more than doubled since June 2002. In an energy-dependent world, that exerts enormous upward pressure on prices. Another possible explanation for low rates on the long bond -- massive speculative buying by hedge funds -- would mean rates are one eggshell away from being scrambled when speculation stops.
A dearth of no-load options
Like other self-directed investors, I prefer no-load funds to the broker-sold type, because they're cheaper. The utility sector, however, is completely dominated by load funds. They account for 20 of the 31 in the group, 14 of the 20 most widely held and all but one of the nine funds with four- or five-star ratings from Morningstar.
The Franklin and MFS funds both have four-star ratings.
The largest no-loads in the space, Fidelity Utilities (FIUIX) and Fidelity Select Utilities Growth (FSUTX), have lousy performance records and only two stars from Morningstar.
American Century Utilities (BULIX) "is better than Fidelity, I think," says Morningstar analyst David Kathman. "If you want a no-load, the American Century fund is the one I would consider the best out of that small group." It has earned only three stars for risk-adjusted performance, or a gentleman's C.
Load funds dominate because, clearly, only brokers were smart enough to direct their clients into utility funds before they got hot. Of the group's total capitalization of $14.82 billion, only 12.8% is held by no-load mutual funds.
So while load-fund customers will have no trouble finding an outstanding utilities fund, self-directed investors are left to choose between two exchange-traded index funds, Utilities SPDR (XLU, news, msgs) and iShares Dow Jones U.S. Utilities (IDU, news, msgs). Their performance has been virtually identical.
But I wouldn't be a buyer at today's prices. No one knows when this party will end, but the odds are it will be sooner rather than later. Once they are cheap, they are well worth looking at in comparison with other income-oriented investments. Until then, they're too risky for me.
At the time of publication, Timothy Middleton owned none of the securities mentioned in this article.
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