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  1. Home
  2. / Investing
  3. / Utilities

Now Is Not the Best Time to Buy Utility Stocks

They are too expensive for what their growth prospects are. 
By TIM MELVIN Jun 15, 2016 | 11:00 AM EDT
Stocks quotes in this article: POR, GS, GS

I didn't get around to reading the Wall Street Journal until fairly late in the day yesterday. When I was done laughing at the story that alleges Goldman Sachs (GS) brokers took advantage of the Libyan Sovereign Wealth Fund (seriously, you have to read this; it would make a great movie) I noted an article by James Mackintosh on the lack of exuberance during this stage of the bull market. In it, he pointed out that investors that have left the bond and fixed income markets in search for yield tend to look for boring familiar names to buy. The article noted that because of this yield-reaching, utility stocks are outperforming most other sectors with a 16% return in 2016. I have not looked at utilities in a while as they have not showed up on my stocks screens in some time now, as yield chasing pushed them out of the valuation range where I might become interested.

I have to say that I have done very well with utility common and preferred stocks over the years. In fact, I have never lost money buying a regulated utility stock in almost three decades. Buying preferred stocks of utilities dealing with nuclear overages that had substantial dividend arrears was one of the spectacular returns during my career. The trick to making money in utilities is the same as it is for any other sector of the market, but the monopolistic tendency and regulatory scrutiny of this industry actually make it a little easier. The trick is simple: Don't pay too much. I have never lost money on a utility stock because I have never paid over book value for one. As long as I have followed that rule and been patient, it has always worked.

Out of curiosity as much as anything else, I did a little research on the industry and selected stocks yesterday. These stocks have had a quite a run the last few years. Buying by yield-seekers has been a big part of the gains, as has a fairly high level of merger and acquisition activity. Low fuel costs as oil and natural gas prices have fallen have helped the industry maintain and even grow earning s little bit. Now we are seeing the sort of "Are you kidding me?" valuations that should be a huge red flag to anyone thinking of putting money to work in this sector.

I looked at Portland General (POR), a stock I recall buying back in late 2009. Back then, I paid about 80% of book value and was getting a yield of over 6%. The EV/EBIT ratio was less than 6x at the time. The economy and the market were still caught up in the idea that the world was going to end any minute, and even if we survived green energy mandates would make it impossible for utilities to grow, much less survive, so pricing was pretty attractive. Since then, the stock has almost tripled in price and paid out north of $6 per share in dividend payments.

Fast forward to today. Portland General shares are trading at 1.65x book value and the EV/EBIT ratio is 18.30x. The yield is just 3%, which may be better than Treasuries but is on the low side historically for utility stocks. The company is not going to show any great earnings growth going forward, and the rate of dividend growth is probably going to slow as the payout ratio. It is a solid company with a decent balance sheet, but at this price it is not a great investment. It looks to me like there is a lot more downside risk that most of the newly minted equity investors who have fled the bond market in search of yield will find comfortable.

I don't want to pick on Portland General. I looked at a bunch of regulated electric utility stocks and found the same thing. There are no electric utility stocks trading below book value and more than a few of them are trading at more than 2x book value. If you bought these stocks back in 2009-2010, you may not want to rush to sell them, but if you have new money to bring to the market and are searching for income, I would suggest you avoid electric utilities at these lofty levels. The economy is growing too slow for anything great to happen as far as earnings or dividend growth, and the piece is too high right now.

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At the time of publication, Tim Melvin had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity | Utilities

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