It's Lights Out For Utilities Investors

While 2011 had most investors muttering to themselves over debt standoffs here and in Europe, shareholders of utility stocks were riding a bolt of lightning to supercharged returns. The industry, known for stability and high dividends, was the best-performing of the Dow sector indexes. The Dow Jones Utility Average returned 14%, not including dividends, and some of the biggest players in the industry performed even better.

Source: YCharts.

As you can see from the chart above, when the market tanked in August, utilities hardly flinched. And since then their outperformance has only increased. Equity returns of 20% plus dividend yields near 5% had shareholders' hair standing on their heads in an otherwise flat year.

Lights out
Those investors still holding electric companies may want to keep a couple of candles and a book of matches handy.

Utility stocks are looking more and more overpriced, driven by investors seeking shelter in high-yielding dividends away from the waves of volatility.  Low-growth utility stocks have become the most inflated with astronomical PEG ratios. The ratio, which divides a company's P/E by its growth rate, is a good measure of value since it accounts for future earnings.  According to standard investing theory, a company's PEG should be 1, and the lower the ratio, the better.  As you can see from the chart below, these companies' PEGs are some of the highest in the S&P.

Source: Yahoo! Finance, Ycharts.

Even factoring in returns from dividends, those ratios would still be near or above two, and looking at their historical growth rate, only American Electric Power impresses.

Similarly, utility share prices seem to move in tandem with the PE10, a price-to-earnings ratio advocated by economist Robert Shiller that uses a company's average earnings over the last ten years to smooth out aberrations.

Let's take a look at a few examples:

Source: YCharts.

Source: YCharts.

Source: YCharts.

As you can see from these three companies, utility stock prices tend to move along with the PE10 ratio, and the PE10 ratios for all three have reached their highest points in the last ten years. These ratios cannot go up forever. As recently as last May, Professor Shiller said he thought that stocks were overpriced, and utilities appear to be one of the biggest offenders. Even worse, the Dow Jones Utilities Titans 30's forward P/E of 14.07 is actually higher than its trailing P/E of 13.01, meaning the sector's earnings should be lower this year than last.

Analyst downgrades
Some analysts have picked up on the concerning figures, recently downgrading a number of utility stocks. JP Morgan lowered its ratings on Con Ed, Southern Company, and Dominion because of their lofty valuations, and Bank of America dropped Exelon down to neutral because of lower power prices in its core markets.

The economy looks to be improving, with unemployment falling and recent good news from the manufacturing sector, and markets have started the year off strong. The S&P 500 is already up 4% this year, despite Standard & Poor's cutting several credit ratings in Europe, and China reporting its slowest growth in two and a half years. Investors seem to have gotten over the European debt crisis, and it's worth remembering that stocks were up about 7% last year before the debt-ceiling debacle killed the market.

Notably, the Dow Jones Utilities Index is down about 3% since the new year. Corporate profits continue to grow, and the market's P/E ratio is relatively low. There is plenty of room for stocks to move up. As the economy improves, look for investors to move their money out of these high-yielding dividends and into investments like cyclicals that stand to benefit the most from a turnaround. Those investors who stick with utilities may end up left in the dark.

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