Utilities Sell-Off Presents Buying Opportunities

We are reaffirming our fair value estimates and economic moat and moat trend ratings for all the U.S. utilities we cover after a three-month pullback that we think now offers buying opportunities.

On a median basis, U.S. utilities now trade in line with our fair value estimates, the cheapest they’ve been since 2015. This is a sharp reversal since Nov. 14, when utilities reached a peak 1.18 price/fair value ratio. Since then, the Morningstar US Utilities Index is down 14% and has underperformed the S&P 500 by 19 percentage points. No other sector has performed as poorly. Since July 2016, when our coverage universe touched a 1.21 price/fair value ratio, utilities have underperformed the S&P 500 by 30 percentage points and returned negative 2%. Other valuation metrics such as price/earnings (17 times forward) and price/book (1.8 times) have contracted sharply.

The sharp rise in interest rates, in line with our outlook, appears to be the primary factor weighing on market valuations. The 10-year U.S. Treasury yield recently rose to 2.85%, the highest since January 2014, making utilities’ income properties less attractive. The spread between the 10-year U.S. Treasury yield and the utilities sector’s 3.3% trailing 12-month dividend yield is the tightest since January 2003 and approaching its 25-year average (16 basis points). The spread was 118 basis points as recently as mid-November.

Utilities’ key fundamental risk is a potential cut in regulated returns, which would reduce our earnings growth outlook. However, regulators have been slow to pull back allowed returns in a persistent low-interest-rate environment. Rising interest rates and tax cuts will take some pressure off regulators to cut utilities’ allowed returns.

For income investors, our top picks are

For Dominion, we expect wide-moat businesses will represent half of the utility’s business mix by 2021 and support 10% annual dividend growth. For PPL, we think investors are overly concerned about potential regulatory changes in the United Kingdom that we believe will probably affect energy suppliers only, to which PPL has no exposure.

We also like Duke Energy, whose highly skilled management team has successfully integrated acquisitions, moved the business away from commodity-sensitive markets, and secured above-average returns from regulators. We think concerns about Duke’s ability to grow are unwarranted, and we see a pathway toward 5.5% five-year growth.

Our top value picks remain