September 21, 2020: Boring Utility Stocks Are Excellent Long Term Winners

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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Thursday October 1, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Boring Utility Stocks Are Excellent Long Term Winners

In the current raging bull market of technology stocks, majority of investors are probably not aware that boring utility stocks for gas, electricity and water companies actually have delivered similar or sometimes better returns with lower volatility for a long term. We probably should use ‘Surprised’ again in our title for this newsletter.

Utility companies are excellent businesses

Let’s first take a look at the long term earnings growth charts for both S&P 500 companies and S&P 500 utility sector companies:

Courtesy of Yardeni Research

One can see that utility companies have more stable earnings but their earnings growth is slower than S&P 500 companies as a whole. This is not surprising as utility companies rely on steady (regular) fees from customers by providing electricity, gas, water and other basic yet essential services. These companies, though usually regulated by states and the Federal government, have a very good pricing power to adjust their prices to keep up with inflation because of their usually monopoly position in their local territories.

These companies also pay higher regular dividends. SPDR Utilities Select Sector ETF XLU, at the moment, pays 4.23% annual dividends, compared with SPY’s 2.16%.

Of course, it’s also not surprising that it’s relatively simple to estimate utility companies earnings and growth. The industry has a high entry barrier for new comers: just imagine to start a new utility company, it would require large capital and stringent regulatory approval, unlike many technology companies, for example. Thus these businesses boast of wide business moat that can help them for a long time.

Now, let’s compare long term stock total returns (dividend reinvested) for VFINX (Vanguard 500) and FSUTX (Fidelity Select Utilities Fund, Note: the sole reason for us to choose FSUTX to represent utilities is FSUTX has one of the longest history. A better and cheaper version for recent years would be Vanguard Utilities VUIAX).

Note, before the latest Covid pandemic correction, in February 2020, FSUTX actually had a better total return than VFINX! In general, FSUTX has a very comparable historical return as VFINX (see the table below).

Risk managed utility investing

Simply buying and holding a utility sector fund can result in comparable stock index like returns. But for many, utility stocks are still way too volatile, just as evident in the above chart.

We can construct tactical portfolios that are based on some sound market indicators to decide whether to invest in these stocks or switch to ‘safe’ bonds. The following table shows the two portfolios that are based on MyPlanIQs’s Composite Market Indicator:

Portfolio Performance Comparison (as of 9/18/2020):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	15Yr AR	Since 7/30/87
P Composite Momentum Market Utility FSUTX	-2.2%	0.1%	9.1%	9.8%	10.3%	10.5%	12.6%
P Composite Momentum Market VFINX VBMFX	-5.5%	2.1%	8.3%	10.3%	12.2%	11.0%	12.1%
VFINX (Vanguard 500 Index Investor)	4.1%	12.4%	11.9%	13.3%	13.6%	8.9%	9.6%
FSUTX (Fidelity Select Utilities Portfolio)	-12.2%	-10.2%	5.2%	9.6%	10.2%	7.7%	9.3%

More detailed comparison >>

In general, one can see (by clicking on the above link and scroll down to a detailed analytics table) that FSUTX has lower volatility or standard deviation (SD) than VFINX. This is expected as in ‘normal’ times, utility stocks are more steady.

Unfortunately, utility stocks are not free from human (over) greed and fear and their prices can also overshoot or undershoot in market extremes. So even though they have lower volatility in good times, they can incur great loss, just like a broad market stock index such as S&P 500.

One way to reduce the volatility while still deriving similar or even better long term returns is to use our Composite Market Indicator as a guide. When the indicator signals a good market environment, a portfolio fully invests in a utility or general stock index fund, otherwise, it invests in a bond fund. In general, during a market downturn, we prefer investing in a safe Treasury fund such as Vanguard intermediate term Treasury index fund VFITX. But since VFITX doesn’t have a long history, we instead chose VBMFX (Vanguard bond index fund) as the alternative.

In the above table, the two portfolios are essentially guided by MyPlanIQ Composite Market Indicator and invest in either FSUTX or VFINX. One can see that just simply using this market timing strategy to invest in FSUTX actually delivers better long term returns since 1987.

The following chart shows how the two portfolios have fared, compared with each other, since 1987.

For income investors

The above data show that utility stocks can perform as well or even better than a broad base market index in a long term. This indicates utility stock sector can be a good diversifier to a broad base stock index. Furthermore, utility stocks usually have higher dividend payments, making it especially suitable to income investors. Specifically, the market timing portfolio P Composite Momentum Market Utility FSUTX has annual dividends ranging from 3.5% to 5.5% for the past 20 plus years. This is because the portfolio basically invests in either FSUTX – a utility fund or VBMFX, both of which have yields around 4% in the past.

Note, again, we would suggest to invest in VUIAX or VPU (Vanguard utilities ETF) instead now as their expense ratios are 0.1% compared with 0.75% of FSUTX. The above portfolio is just for historical comparison purpose.

In the coming years, unfortunately, the yields from a utility fund or an intermediate term bond fund will be lower because of the extremely low interest rate environment. The extra income thus has to come from price appreciation captured tactically. This means income investors might have to resort to selling some portion of a holding to generate income.

Market overview

Stocks are somewhat stuck. We point out that there are at least several major factors that can potential derail the current market rally that’s over extended and very over valued: first, we are just less than one and half months away from the US presidential election. Political tension has risen dramatically, especially from the recent supreme court justices selection. Other election related surprises (so called ‘October Surprise’) include geopolitical friction between the US and China and income stimulus bill wrangling. The other major factor is the possible second wave of the pandemic might materialize, as what Europe started to experience now.

On the other hand, we do see more encouraging signs of the market rotation: as stocks retreated recently, high growth stocks were hit hardest, thus narrowing the gap among stocks. If stocks can maintain the current uptrend, it might be even likely that in the next rising phase, other laggards such as utilities and small cap stocks will rise strongly. That will improve market strength uniformity.

Again, we shouldn’t rely on our subjective opinion and should follow our strategies instead:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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