Utilities and Portfolio Construction

In my previous post The Blue Chip Moderate Risk Portfolio I released my moderate risk model portfolio.

Those of you who have had a chance to review that post might be wondering why I have such a large overweight to the Utilities sector as Utilities account for 12.8% of the portfolio’s total equity exposure while making up just 2.3% of the S&P 500 . Exposure to Utility stocks account for 8.4% of the model portfolios total exposure and just 1.4% of the benchmark.

In today’s post I will explain my thinking behind this position.

Historically, over the long-run, the Utilities sector has not delivered returns that have matched the broader market. Over the past 20 years, Utilities have delivered a total return of 8.6% compared to total return of 9.5% for the S&P 500. Utilities have also underperformed over the past 15 and 10 year time periods.

Based on this fact you might be wondering why anyone would recommend a structural overweight to a sector that has underperformed historically. The reason is that Utilities stand out for their relatively low correlation with the broader market.

In my prior post How To Beat A 60/40 Portfolio I discussed the investing principle known as Modern Portfolio Theory which argues that any given investment’s risk and return characteristics should not be viewed alone but should be evaluated by how it affects the overall portfolio’s risk and return.

Low Correlation To Broader Market

When investors think about diversification two common asset classes to include tend to be corporate bonds and foreign stocks. However, as shown by the chart below these asset classes have historically had a very high correlation to the S&P 500.

As shown by the chart below, over the past 10 years, foreign stocks have exhibited an average correlation of 0.74 to the S&P 500 and high yield bonds have exhibited an average correlation to the S&P 500 of 0.79. While there is some diversification to including these asset classes in a portfolio, the diversification benefit is fairly limited.

Comparably, the Utilities sector has exhibited an average correlation of 0.45 to the S&P 500 over the past 10 years. This degree of correlation is roughly inline with investment grade bonds which can be proxied with the iShares iBoxx IG Corporate Bond ETF (LQD). However, investment grade bonds have delivered much lower total returns historically than Utilities. Over the past 20 years LQD has delivered a total return of 3.98% vs the 8.6% return delivered by the Utilities sector.

Other sectors with low a correlation to the broader market include Consumer Staples, Energy, and Healthcare but Utilities stand out as having a lower correlation and thus more potential as a portfolio diversification tool.

The relatively low degree of correlation between Utilities and the broader market is driven by the characteristics of the Utility business. Individuals and companies require electricity regardless of economic conditions. While commercial demand can fluctuate based on economic conditions, the reality is that most regulated Utilities face very little cyclicality in terms of their earnings.

While Utility companies are subject to less economic risk than most companies, they are subject to other forms of risk. Specifically, the industry faces significant regulatory risk as Utilities are highly regulated and the amount they can charge is often determined by state governments. Additionally, Utilities face environmental risk as a number of Utilities, most notable PG&E Corp and Hawaiian Electric, have come under fire and faces liabilities related to their role in recent wild fires.

For this reason, I believe ETFs such as the Utilities Select Sector SPDR ETF (XLU) represent a good way for investors to get exposure to the sector.

Intrinsic Valuation Fair Value Estimate

Given the fairly predictable nature of dividend growth by Utility companies, a dividend discount model is a tool which I view as appropriate to guage fair value.

Historically, the annual dividend paid by XLU has grown at a ~3.9% CAGR over the past 10 years. I expect this growth rate to continue going forward. In order to find the appropriate discount rate, I assume levered beta of 0.58 which is the estimated sector beta per analysis done by NYU Professor Aswath Damodaran. Over the past 10 years, XLU has realized an average 3yr trailing levered beta of 0.31. Thus, I believe the 0.58 is a more conservative estimate. Other key assumptions in my analysis include a risk free rate of 4.1% (based on the current 10 year Treasury) and an equity market risk premium of 5.5%. Based on these assumptions, I find that a conservative fair value for XLU is ~$65.8 per share which is 8% above XLU’s current share price of $61 per share.

Holding all other assumptions constant and assuming a beta of 0.5, XLU’s fair value would be $75.5 per share.

Takeaways

My decision to have an overweight allocation to the Utilities sector as part of my moderate risk portfolio is driven by structural factors and my views regarding fair value of the sector. I view Utilities as a better source of diversification relative to international equities and corporate bonds. While those market segments still have a role to play in a well diversified portfolio, I prefer to have more exposure to the Utilities sector right now.

Overall, the blue chip portfolios moderate risk portfolio is overweight equities (66% vs 60% for the benchmark) but much of this is due to the 7% allocation to XLU which I view as an attractive replacement for fixed income exposure.

While it can be argued that high quality bonds currently offer a modest yield premium vs Utilities, I still believe Utilities are posited to provide a better total return than high quality bonds due to solid dividend growth.

My view regarding this positioning would shift if there is reason to believe that the Utilities sector will be unable to deliver dividend growth going forward which is inline with historical averages or if the valuation picture changes to become less favorable for Utilities vs other market segments.

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