QQQ - IDU: How Utility ETFs Just Got More Exciting

2023-12-01 15:42:20 ET

Summary

• iShares U.S. Utilities ETF is attracting renewed attention due to the current interest rate environment and the push towards green energy.
• The ETF is based on the Russell 1000 Utilities RIC 22.5/45 Capped Index, which includes high-quality regulated and nonregulated utilities.
• Lower rates and tax incentives for infrastructure expansions make utilities an attractive investment, with the potential for multiple expansion and dividend growth.

"Growth" and "utilities" in the same sentence, without the word "not" in between? You read that correctly. A combination of the current interest rate environment and steady national march to convert to green energy prompt renewed attention to iShares U.S. Utilities ETF ( IDU ). This beaten-down defensive ETF possess a portfolio poised for multiple expansion and growth.

It is also something I think the late, great value investor Charlie Munger, Warren Buffett's long time investing partner, would have appreciated. Mr. Munger passed away earlier this week, just 5 weeks shy of his 100th birthday.

Domestic utilities… really?

Why pay any attention to utilities now, when the sector, which represents only 2.4% of the S&P 500 SPDR ETF ( SPY ), has been one of the worst performers for 2023? It starts with the high-quality index IDU is based on, the Russell 1000 Utilities RIC 22.5/45 Capped Index. It contains predominately high-quality, stable regulated monopoly utilities and “growthy” nonregulated utilities poised to capitalize on the 2022 Inflation Reduction Act (IRA) tax incentives.

Recent CPI and PPI results showing a stable to downward trend in inflation have supported a broader consensus that the Fed may have come to the end of its rate hikes, with others even expecting potential rate cuts. Lower rates benefit utilities as they have high capital expenses funded through borrowing. The IRA tax incentives intend to support ambitious infrastructure expansions over several decades by lowering regulated and nonregulated companies’ cost of capital as they build more power grids, EV charging stations, and invest in clean energy alternatives.

There is a strong correlation between Treasury yields and regulated utility yields, which leads many investors to consider utilities a proxy for the bond market. In fact, for many institutional investors who have a mandate to be fully invested and only use stocks, utilities are often the closest thing they have to a diversifier. This is one of those unwritten rules of Wall Street that becomes a self-fulfilling prophecy: rates drop, utility stocks get a bid. It happens often.

With 52% of IDU's portfolio in the 10 largest holdings, this ETF is in sync with my strong preference for top-heavy, concentrated funds. As shown below, utility stocks are not the yield hogs they once were, but they still pay dividend rates above most other sectors. And, as noted above, some of that yield has been traded off for growth potential.

Utilities: sweet spot for infrastructure spending

Utility valuations are based on earnings and dividend yield growth, along with the ability to recover expenses in a monopoly service area. The more pro-business the state the utility operates in, the better the potential performance as they are able to pass through their capital expenses through rate increases.

And of course, you need good management teams to grow earnings and dividends. With the additional tax incentives offered by the IRA, both regulated and nonregulated utilities will have lower construction and operating costs for green energy projects. This will keep pass-through expenses to the customers lower and more politically palatable.

While Treasury yields remain fixed, utility yields typically grow over time. Utility stock prices can also appreciate through earnings and dividend growth, unlike Treasury prices.

Year-to-date, the Utility Sector has been one of the worst performers within the S&P 500. IDU is down close to 8% compared to a rise of nearly 20% for SPY. The sector is trading with forward multiples under 15x next year’s earnings, near a 20-year low.

With inflation coming down and potential rate cuts on the horizon, this low beta sector has the potential for multiple expansion, in addition to dividend growth. Added to the enormous need to expand the national electric grid and tremendous tax incentives offered in the 2022 IRA, IDU is poised to trade meaningfully higher. With captive consumers, growth and stability in the defensive utility sector can potentially be found in IDU.

Risks to the thesis

IDU is a low beta (0.6) investment, which means it is typically about 40% less volatile than the broad stock market. However, utility valuations can change significantly with changes in interest rates, current and future government regulations, new technologies, and unforeseen macroeconomic and political events.

There is also the possibility, as with all value situations, that the market won't recognize that value so quickly. This was the case back in the late 1990s and into the year 2000, which in many ways resembles the current investing climate.

Look no further than the chart below. QQQ spent time grinding higher, then took off at a rate rivaled only by the current rate of spending by the US Congress! But Utilities not only lagged behind the "excitement," they were down for most of the year. Note that this is not 2023. It is 1999!

Then, the Dot-Com Bubble era, like a fireworks show, ended with its loudest phase. This chart covers the last 12 months of that bubble, ending on 3/31/2000. From that point forward, this happened. This is the 12 months after the 12 months shown above. A very different story. Value swung back into favor, suddenly, and convincingly.

While it is no longer the late 1990s (thankfully), value investing, including in the form of a well-crafted portfolio of quality utility stocks, should be moving up the ranks on investors' watch lists. I know they are on mine. And while my current enthusiasm stops at a Hold rating for IDU, that has more to do with my overall caution regarding equities in general, at least until I see more evidence of a sustainable upside breakout in more than the Magnificent 7 stocks.

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