US utilities stocks have trailed the broader equity market by a wide margin so far in 2021, having just posted their poorest first-half relative performance since 1997. In fact, the underperformance has become chronic: The sector has now lagged the market by roughly 40% over the past three years – its worst multiyear stretch going back to the tech bubble of the late 1990s.
Neither I nor any other member of the utilities team here has seen anything like this during our careers. So what gives? Utilities were neither COVID “winners” nor “losers” in 2020. And then the US stock market’s persistent “seesawing” between the value and growth styles has left utilities out of this year’s market gains. Increased inflation and fears of higher interest rates have also hurt the group to some degree in recent months.
But there is a silver lining. In the wake of their underperformance, US utilities have been trading at a big discount to their “normal” level. And the sector’s outlook is bright and visible, in my view, supported by long-term trends of decarbonization and electrification. Given this combination of a strong investment thesis and attractive relative valuation, now may be an opportune time to take a closer look.
Four reasons to consider US utilities
1. They look attractive on a relative basis. From a relative valuation standpoint, the price/earnings (P/E) ratio of the S&P 500 utilities sector versus the overall index was 22% below its average as of midyear 2021 (Figure 1). In addition, the sector’s dividend yield was at a historic high relative to the yield offered by the 10-year US Treasury bond.
2. The structure of the sector has improved meaningfully. In my judgment, investing in US utilities is much “cleaner” and simpler today than it was in prior decades. The turmoil of deregulation that plagued the sector in the late 1990s and early 2000s is no more. The majority of companies are now regulated and have streamlined their operations.
3. A “super capex” cycle is coming for all segments of the utility value chain. The US has a goal of carbon-free power generation by 2050 at the latest. Aging infrastructure and the need to accommodate climate change and ongoing decarbonization will also require significant investments in energy transmission and distribution.
4. US utilities should experience accelerating earnings-per-share (EPS) growth for at least the next five years, if not through the end of the current decade. The sector should benefit from robust and rising capital expenditure in the period ahead. For most regulated utilities, I expect a 6%-8% compound annual growth rate (CAGR) for their regulated asset base (RAB) over the next five years, which translates to 5%-7% EPS CAGR. How would that compare with the sector’s history? Faster by 1%-2%, except for the brief period from 2006-2009.
A word about interest rates and inflation
The utilities sector has tended to underperform during past periods of rising interest rates and inflation, as we saw during the first half of 2021. Both remain investor concerns in today’s environment. However, I suspect these worries may already be largely “priced in” for most utilities stocks following their recent lackluster performance.
Final thoughts on US utilities
When will the market begin to recognize utilities’ potentially undervalued attributes, including their ability to deliver ~10% annual total returns that are not overly sensitive to the prevailing economic cycle? Hard to say. But if I’m right here, equity investors should consider positioning their portfolios accordingly sooner rather than later.