The market for energy efficient LED lighting is growing at 45% annually, part of a larger move towards greater energy efficiency in US households.
With shrinking demand, utilities will be forced to raise rates on remaining customers, leading to an even higher adoption of solar power and energy-saving devices. According to Barron’s, half of electric-utility executives expect these trends to send their industry into a “death spiral” within the next decade.
Utilities are on a tear. Without accounting for dividends, the Utilities Select Sector SPDR ETF (XLU) is up 17% so far in 2016 and 28% over the past three years, in both cases outperforming the S&P 500 (SPY). Stocks that are supposed to be safe income plays have delivered major capital gains.
It’s not hard to figure out why this is happening. Interest rates have been at historic lows for several years now. As the Fed continues to push back its timetable for raising rates, bond investors are capitulating and turning to utilities as a source of yield.
This run-up has many people uttering an unusual phrase: “utilities bubble.” Could these traditionally safe stocks be dangerously overvalued and setting up for a crash? If so, how should investors manage their portfolios to mitigate this risk?
Utilities’ Profits Do Not Justify The Stock Performance
Let’s quickly dispense with one possible counterargument: that the strong run for utilities stocks is based on improved financial performance and not yield-chasing investors. Figure 1, which shows the trends in average return on invested capital (ROIC) and cumulative after-tax operating profit (NOPAT) for the sector over the past few years, clearly shows that profits are flat to down and not driving stock valuations higher.
Nor do macro industry trends support hope for growth in future cash flows. In fact, the exact opposite is true.
Solar panel installations are projected to grow by 119% in 2016.