IDU: Utilities No Longer a Safe Haven in Troubled Times

A five-year run-up for the usually staid utilities sector turned the stocks of generators and distributors of electricity, water and gas from the favorites of slow-and-steady investors into growth stocks that strongly outshone the broader market.

iShares Dow Jones U.S. Utilities ETF (IDU) boasts a five-year annualized return of 16.9% (through May 29), nearly seven percentage points better than the S&P 500.

But IDU investors felt the other side of that new reality in the opening months of 2008 when the sector—long known as a safe haven in troubled economic times, thanks to the usually recession-proof need for power—took a hit during the mortgage crisis and credit-crunch-induced downturn. IDU’s NAV dropped 11.7% during two-plus weeks in January and stood down more than 11% year to date through late March.

The fund also dipped nearly 12% last summer, and while it has recovered both times and ended May with a three-month gain of 10%, that’s not the kind of volatility utility investors were accustomed to, prior to this decade.

Until that five-year run, utilities represented some of the equity market’s best options for safety and income, with a history of mild struggles in bull markets and outperformance in recessions. But utility stocks tanked during the market downturn of 2001-2002, before starting their multiyear run.

“The current situation makes them not nearly as defensive as they have been for the last 60 years,” Morningstar’s Paul Justice told the International Herald Tribune. “Typically,” he added, “utilities are not at the end of a five-year bull market when a recession starts.”

That makes this an interesting time for IDU, which has been locked into the upper third of our ETF Momentum Tracker Sector Momentum Table for more than six months now, hovering between the 14th and 18th spots (out of 44).

The fund passively tracks the Dow Jones U.S. Utility Index, holding about 75 stocks as a representative sampling that closely follows the bogey. The index is market-cap weighted, meaning larger stocks dominate, with more than 44% of assets invested in the top 10 holdings.

Likewise, the cap weighting results in a heavy preponderance of electrical utilities, recently accounting for 72% of assets and nine of the top 10 holdings. There are smaller stakes in gas, water and multi-utilities.

Morningstar analyst Haywood Kelly said the fund was “on the cusp of bargain territory” back in February, when the fund was down nearly 6% year to date. In the last month, the utilities sector’s average return of 5.3% was second only to energy, according to Morningstar.

Kelly equates the growth rates of IDU’s underlying companies as low (“basically GDP-like”) and—like the utility stocks of yore—heavy on dividends: IDU carries a dividend yield of 2.5%.

Thanks to rate cuts and an increase in credit spreads, those dividends aren’t necessarily a draw to income investors, who now have other options. Aside from that, many utilities face the challenge of forthcoming major capital expenditures, both to meet the needs of growing populations and to provide environmentally friendly energy, due to either customer demand or regulatory issues. For now, regulations vary by state, but the federal government may soon be involved. The high price of coal is also helping firms with strong nuclear and natural gas generation facilities.

Those expenditures could pressure returns in the short term but could also benefit non-regulated companies such as top IDU holding Exelon (EXC) (shares up 9.5% year to date), the largest U.S. operator of nuclear plants, and regulated firms with historically favorable regulatory environments, according to Morningstar, such as No. 2 holding Southern Company (SO) (shares down 6.4% YTD), which is allowed higher returns than many regulated firms.

The possibility of federal legislation to curb carbon emissions could well benefit utilities with considerable investment in wind and solar projects, such as No. 4 holding FPL Energy (FPL), whose stock price is essentially flat for 2008. In a late May shareholder meeting, FPL CEO Lew Hay III said the company expects that such laws would boost its annual pretax earnings by more than 45% by 2012. FPL is the country’s biggest supplier of wind and solar power, and it expects to see a benefit if the United States establishes either a cap-and-trade system—which has been proposed and may hit the Senate floor this week—or carbon fees.

The only nonelectric utility in the top 10 holdings is No. 9 Williams Companies (WMB), a natural gas firm. Williams has the best one- and five-year returns among the top 10 holdings, at 21.8% and 377.9%, respectively. The company, along with others in natural gas, have benefited from the rise in gas prices, up more than 40% in the last year.

Still, for now, IDU relies heavily on electrical utilities, and with that landscape in the midst of change, the sector and fund no longer virtually guarantee steady returns or a safe haven. It does, however, have the potential to continue growing.

Comments

[aquaculture]

youtube.com/watch?v=Sd...

[barnburner]

gotta tell ya Utilities are boreing and while they used to be equated with bonds it's no longer true. Utilities no longer move with energy prices as they used to do so unless they have an outstanding dividend - who cares?

[John couger]

I started a position in AEP two weeks ago, was planning on buying more and holding for 6-12 mo. This article has me a little concerned. Should I be?