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Buyer Beware – Utility Stocks Are a Bad Play Right Now

I love utility stocks ... but they're overvalued here


I have never lost money on a utility stock in 28 years of investing. I know that’s a bold statement, but I have the records to prove it. There’s a secret to my approach to buying utilities – it’s pretty much infallible.


I buy them below book value in bad markets and sell them when the world refuses to end and rights itself. That’s it.

As a rule of thumb, I buy utility stocks below 90% of book value and sell them between 1.5 and 2 times book value, collecting a huge pile of dividends while holding them. Next to small banks, regulated utilities are my absolute favorite sector of the stock market…

…and I do not own a single share of any domestic utility right now.

I was big buyer back in 2008 and 2009 of utility stocks like Portland General (POR), Pepco (POM), PNM Resources (PNM), Teco (TE) and Duke (DUK). They all traded at pretty good discounts to their asset value before rebounding. (I sold in the past two years for enormous gains.) I used this same strategy in the market selloff of 2002-2003, the credit crunch of 1998, the aftermath of the nuclear overruns in the early 1990s and right after the crash of 1987.

And I will do it again in the next market meltdown.

But I’m not a holder today, and I’m not buying here.

Lots of folks suggest utility stocks as a source of income. And at first glance it seems like an OK idea. After all, the average utility yields 3.5% right now — better than you can get form many income alternatives. A selective buyer could buy utility stocks like Potomac and Teco that still sport yields over 5%, which is a great return in a yield-starved world. But for me, the potential downside risk in utility shares is far greater than the dividend stream can provide.

The Utilities SPDR (XLU) has gone up along with the market and gotten a strong tailwind from yield-chasing buyers. It has doubled off the 2009 lows, and none of the utility stocks it holds are cheap anymore. The average utility stock is trading at 2.4 times book value and is just too expensive to buy. There is not one single utility stock trading below book value right now, much less at 90% or less of book. (The cheapest utility stock I could find is Missouri-based Great Plains Energy (GXP) at 1.24 times book value.)

In the current slow-growth economy, utilities are unlikely to see the type of earnings and dividend growth needed to push the shares higher. Many of them also are facing closing nuclear and coal-fired plants — that reality is going to add to the cost structure and limit earnings for the next several years at least. Rising interest rates could also depress earnings and spur selling in the utility shares.

You can pay too much for anything in the stock market … and right now utility stocks are just too rich.

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

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