Utility ETFs May Be Overvalued

The utility sector has been historically safe, but is it too safe for your money?

Over the course of the past five years, utility ETFs such as the iShares Dow Jones U.S. Utilities Fund(IDU Quote) and the Utilities Select SPDR(XLU Quote) have seen price appreciation of approximately 100%. In 2007, these two ETFs were up 13.5% and 16.3%, respectively.

Not too shabby.

With all of the volatility in the market recently, there's certainly a compelling argument that these utility ETFs might be a safer, more stable investment than the market itself. They also have dividend yields between 2.5% and 3.0% and are fairly defensive in nature, given the high degree of inelastic demand for many utilities.

The question now is whether these ETFs will continue to trend upward in line with their past performance, or whether other market sectors will leave these funds behind in the quarters ahead.

Richard Romey, president of ETF Portfolio Solutions, isn't convinced that investors should overweight their portfolios with utilities going forward.

"I'm not particularly bullish on utilities right now, but they do have a place in the portfolios of long-term investors," he says.

Jim Paulsen, chief investment strategist for Wells Capital Management, holds a sentiment similar to Romey.

"I don't really like utility stocks right now," he says. "I think that they are overpriced on a relative basis due to investor fears driving up the values of defensive stocks like utilities."

Although Justin McCann, a utility analyst for Standard and Poor's, isn't any more bullish toward utilities than are Romey and Paulsen, he does see some bright spots within the industry.

Among the top holdings of these two ETFs that McCann likes are Entergy(ETR Quote), Progress Energy(PGN Quote) and Public Service Enterprise Group(PEG Quote).

"We think Entergy has been oversold," McCann says of the stock's 9.1% year-to-date decline. "Its plan to spin off its nonutility nuclear business by the end of the year will allow the company to fetch a higher multiple."

Progress is yielding 5.9% and is trading just above its 52-week low. "We like Progress Energy on a valuation basis," McCann says of the electrical company. "Its high-dividend yield is attractive."

Public Service shares took a hit last week when management announced forecasted 2009 earnings that were below analysts' expectations.

"Its prospects might not be as good as before, but we still see above average earnings growth for the company going forward," McCann says.

McCann also likes Constellation Energy Group(CEG Quote) and Exelon(EXC Quote).

Greg Gordon, an analyst for Citigroup, also thinks that there are some attractive utility plays.

"We recommend that investors buy lower payout ratio, but higher earnings growth ideas like American Electric Power(AEP Quote), CMS Energy Corporation(CMS Quote) and Wisconsin Energy Corporation(WEC Quote) that offer superior total return prospects but trade at discounts to higher payout ratio names," he wrote in a research report.

"We also like out-of-favor yield-oriented names like DTE Energy Holding Company and Westar Energy(WR Quote) that are cheap in part due to regulatory risk overhang and/or recent negative earnings revision."