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Why Utilities Are Still Attractive despite Their Valuations

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Utilities are up approximately 20% so far this year, largely in line with the Dow. While almost all utility stocks are looking expensive, a T. Rowe Price analyst has called utilities “the most underappreciated” sector.

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Utilities look expensive

These defensives have had an unusual rally this year buoyed by broader market volatility. Investors have continued switching to utilities throughout nearly the entire year. They’re seen as safe because of their slow movements and stable dividend payments. This year the Fed lowered its benchmark interest rates by 75 basis points, which also supported utilities’ rally.

According to an article by MarketWatch, T. Rowe Price’s head of investment strategy, David Giroux, believes that the utility sector is the most beaten-down sector in the markets. He also said that utilities offer the best risk-adjusted return opportunities for the future.

However, these defensives are currently looking pretty expensive in historical terms. The top utility stocks are trading at over 19 times their 2020 earnings—a big premium compared to their historical average valuation of around 17x–18x. On top of that, paying close to 20 times for slow-growth companies like these seems unwarranted.

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Top utility stocks: Valuations

Renewables giant NextEra Energy (NEE) is trading at 26x its forward earnings, while Southern Company (SO) is trading 19x its forward earnings. Both stocks are trading close to their all-time highs.

American Electric Power Company (AEP) and Xcel Energy (XEL), companies that Giroux mentioned, look to be trading at premiums as well. AEP is trading at 21x its forward earnings against its historical average of 18x. XEL is trading at 22x its forward earnings. Its historical average is around 19x. Thus, these two look expensive compared to their historical averages and their peers. AEP is up about 21%, while XEL has surged around 25% year-to-date.

Renewables power generation

According to Giroux, utility companies can enable faster earnings growth if they use more renewables for power generation. By doing so, they’ll lower the cost of generation, which will grow their rate bases and profitability without affecting power bills.

Although US utilities have been shifting their generation from coal and natural gas to renewables, the switch has been slow. In 2018, renewables contributed almost 17% of total power generation in the US. At the same time, coal and natural gas contributed approximately 65% of total power generation. With that said, American Electric Power Company and DTE Energy (DTE) are some of the heaviest fossil fuel users for power generation. Coal contributed around 45% each to AEP’s and DTE’s total power generation. NextEra Energy is the biggest power company and has unmatchable renewables assets. It’s also one of the fastest-growing utilities in the country.

Dividends

Utilities (XLU) continue to look attractive from a dividend standpoint. On average, they offer a yield of around 3%. The top companies’ average dividend growth could be around 4%–6% for the foreseeable future, which looks reasonable. Also, they’re some of the least exposed companies to trade war tensions and economic cycles, which is a big concern for broader market companies. Utilities’ expected earnings growth rate of around 4%–6% might be enough to facilitate dividend payments in the near future.

Read Top Dividend Stocks from Utilities to Combat Recession for more info.

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