US Utilities: Don’t Overpay for Yield

Wednesday, July 25th, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

As short-term interest rates remain at or close to zero, investors starved for income should be wary of overpaying for yield, particularly when it comes to US utilities.

As I write in my new Investment Directions monthly commentary, I continue to prefer dividend funds and the global telecommunications sector for investors searching for yield. But some segments of the market – such as US utilities — are looking expensive and should likely be avoided.

I continue to hold an underweight view of US utilities for two reasons:

1.) Valuation: Investors have pushed US utility stocks up too far as US utilities currently look even more expensive than they were back in January. US Utilities are currently trading at nearly 15x earnings, versus an average since 1995 of around 14.5x. And the stocks are even more expensive when you compare their valuation to the broader market. As a regulated industry, utilities typically trade at a discount to the broader market. Since 1995, US utilities have traded at an average discount of roughly 25% to the S&P 500. Today, however, US utilities are currently trading at a more than 8% premium, the largest since late 2007.

2.) Profitability: The premium can’t be justified by US utilities being more profitable than in the past. In fact, the US utilities industry is currently less profitable than its long-term average. Return on earnings for US large cap utility companies is currently 10.5%, the lowest level since 2004.

So why are investors paying a near 10% premium to invest in a sector whose profitability is close to an eight-year low? The answer: US utilities have benefited from investors’ flight to safety and flight to yield. To be sure, if the market experiences a major correction, US utilities would likely outperform given their low beta (a measure of the tendency of securities to move with the market at large). However, absent a major correction, I believe a combination of stretched valuations and lackluster profitability suggests that US utilities are likely to continue to trail the market, even in a slow growth environment.

As I wrote in a recent post, my preferred vehicles for seeking yield are dividend paying equities, such as the iShares High Dividend Equity Fund (NYSEARCA: HDV), given its low beta and quality screen; the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE). For investors willing to take the added risk of sector exposure, I like the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA: IXP).

And for investors still looking for exposure to utilities, I continue to hold a neutral view of global utilities, particularly international ones available through the iShares S&P Global Utilities Index Fund (NYSEARCA: JXI).

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long HDV, IXP, IDV

Investing involves risk, including possible loss of principal. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility.  International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

There is no guarantee that dividends will be paid.

Tags: Amp, Beta, Cap, Chief Investment Strategist, Dividend Funds, Earnings, Global Telecommunications Sector, interest rates, Investment Directions, Investors, Ishares, Nbsp, Profitability, Russ, Segments, Tendency, Term Interest, Utilities Industry, Utility Stocks
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Risky Business (Horrocks)

Wednesday, August 18th, 2010

This article is a guest contribution by Robert Horrocks, CIO, Matthews Asia.

Risk and uncertainty are part of everything we do as investors. Much energy goes into trying to understand these elements, and many a computer keypad has been worn out in attempts to write about them. There is a vast body of academic literature that discusses risk and uncertainty. Describing their role in finance has earned more than one Nobel Prize. And yet there remains some distance between what the academic theories define as risk and what the experience of the practitioner is, particularly when it comes to how we think about risk when managing Asian equity portfolios.

From an academic point of view, risk should be something that varies in proportion to returns, the riskier something is, the higher return we should get for investing in it. Risk should also be calculable, in order to know what the trade-off between risk and return is, we have to be able to measure it. Risk that cannot be calculated is called uncertainty. Risk is what you can try to manage; uncertainty is what you can never fully know or calculate. Branching out from this theory, academics tend to treat risk as the volatility of returns, how much an investment’s prices “bounce around” its trend value. Simplistically, the more volatile the security, the higher return needed to justify buying it.

The only trouble is, it doesn’t seem to work that way in reality. Several studies have shown that volatility does not have this suggested relationship with returns. In my own work in the Asian context, investors are rewarded with better returns for taking on volatility only up to a point. After that point, returns to the highest volatility stocks on average can be worse than those for stocks of average, and even lower, volatility. So, it pays to push the risk curve only so far, and that point is somewhere a little beyond average volatility. Nor does it seem that high beta portfolios generate, on average, better returns than low beta portfolios.1

Seeing this problem, academics and practitioners have added other risk factors to their models. These began with market sensitivity (beta), company size (market capitalization) and value (book-to-market), but the list of risks was progressively expanded to include factors as diverse as leverage, volatility, size, valuation, momentum, return on capital, growth and earnings sustainability. This seems sensible at first sight, but is not that intuitive because in many cases it is not clear that taking on extra risk (as one would commonly define it) yields better returns.

Investing in smaller companies may be more risky and, therefore, investors should get a premium. But value? Why should I get an excess return from buying cheap stocks? Surely, if it is a risk factor, I should get the excess return from the risk of buying expensive stocks. The same can be said of many “quality” measures. I have found in Asia that financially sound companies do not return, on average, less than financially weak ones. Of course! (You might think.) But that is a problem for the theory of risk, surely, most investors feel they should be rewarded for taking on more risk and not for playing it relatively safe. Many of the risk models out there are actually return models, they describe what drives stock prices, rather than where the dangers are. If you think that focusing on cheap, high quality, small companies is a good generator of returns, you should be maximizing this exposure, not minimizing it.

Tags: Academic Literature, Academic Theories, Academics, Asian Context, Asian Equity, Attempts, Beta, BRIC, BRICs, Computer Keypad, Curve, Elements, Equity Portfolios, Investors, Nobel Prize, Point Of View, Proportion, Risk And Return, Risk And Uncertainty, Risky Business, Stocks, Volatility
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July and Emerging Markets

Sunday, July 4th, 2010

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors.

There’s no shortage of bleak news out there that’s weighing heavily on the markets, but we could be coming into a positive period for emerging markets investors.

The chart below, from Jim Lowell at Dow Jones MarketWatch, shows that July tends to be a good month for emerging market equities.

The sector’s beta-weighted performance in July tops 2 percent on average, far greater than any other asset class on the chart.

Of course, emerging markets can be highly volatile and there’s no assurance that this month will follow the pattern. But Lowell’s observation is certainly timely and may be of value to investors looking for opportunities in the current market.

Our experience is that seasonality is one of many important variables to monitor to keep a finger on the pulse of the market.

We have found it useful over the years to watch the seasonality of gold, oil, copper and other commodities as part of our broader approach of tracking both short-term and long-term cycles.

Tags: asset class, Beta, Ceo, Chief Investment Officer, Commodities, Copper, Current Market, Dow Jones, Emerging Market, Emerging Markets, Finger On The Pulse, Frank Holmes, Gold, Gold Commodities, Jim Lowell, Marketwatch, Observation, Seasonality, Tops, U S Global Investors, Variables
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