Zachary is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The utilities sector has often been considered a "widows & orphans" group of stocks, with a long history of paying healthy and reliable dividends that makes these stocks safe enough for even the most conservative investors. Since the beginning of the summer, these shares have declined significantly -- but even at discount prices, they still have serious risks.
The great capital rotation
To understand the current dynamics for this basket of stocks, we first have to take a look at what has happened to the group over the last several years. Utility stocks have been popular because of the high dividend yields paid by the individual companies.
For example, Duke Energy (NYSE: DUK) pays an annual dividend yield of 4.5%. Southern Company (NYSE: SO) currently pays investors 4.6%, and Dominion Resources (NYSE: D) has a 4% dividend yield. These are three of the largest stocks in the Utilities Select Sector SPDR (NYSE: XLU) - an exchange traded fund that tracks the utilities sector.
In an effort to stimulate the US economy, the Federal Reserve has reduced target interest rates to extremely low levels. The Fed has also been aggressively buying Treasury securities, along with mortgage-backed securities. This has had the effect of driving bond prices higher across the board, and sending interest rates sharply lower.
Why does this matter for utilities stocks? Well, with Treasury bond prices extremely high (and corresponding interest rates extremely low), a large portion of "safe" investors have been forced to find other areas to park their capital.
Investors in need of income have sold low-yielding treasuries and mortgage backed securities, and rotated their capital into stocks with high dividend yields. This capital rotation has pushed dividend-paying stocks steadily higher, causing valuations to rise materially over the last four years (see chart below).
Over the past few weeks, investors have begun fretting about how and when the Fed will start reducing its massive bond buying program. The most recent Fed announcement indicated that these bond purchases will likely be slowing over the next few months, which will reduce the overall demand for Treasury and mortgage bonds.
Interest rates are already starting to increase, and the effects are being felt in the broad economy. Last week I noted that rising mortgage rates were creating challenges for homebuilders.
As rates increase, conservative investors have an incentive to move their capital back into "safe" areas such as Treasury bonds and mortgage backed securities. This is especially true as volatility picks up in the stock market. As this safe capital flows out of dividend paying stocks, and into bond securities with more attractive yields, the utilities sector is vulnerable to further price declines.
No earnings growth
It is important to note that while stock prices for utilities have increased over the past several years (along with valuations as we saw in the chart above), actual earnings levels for these stocks has not changed much.
Below is a chart of earnings per share for Duke Energy, Dominion Resources and Southern Company. As you can see, there have been some gyrations over the past several years, but earnings are still at roughly the same level they were five years ago.
If earnings have been stagnant, then why have utilities stocks increased in value? Basically, these stocks are just responding to the high investor demand for yield. The increase is not because the companies are stronger or more profitable than they were before.
As an investor, I am certainly attracted to the dividend yield that these companies offer. However, receiving a 4% yield does not appear to offset the risk of these stocks continuing to fall significantly over the next few months.
If capital continues to rotate out of high dividend stocks and into fixed income assets, utilities stocks could easily drop another 20% to 40% and still be above the valuation levels from a few years ago.
Rather than take advantage of a short-term drop in the utilities sector today, I would prefer to wait until valuations are at historically low levels. Assuming the actual quarterly dividend payments remain the same, waiting for lower valuations would also give me a higher yield on my investment because of a lower purchase price.
Utilities stocks may pay a healthy dividend and be materially less expensive than they were several weeks ago. But there is still too much risk in these stocks for me to justify buying right now.