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If You Must be in Utility Stocks – Like This Fidelity Guy – Here’s What You Do

If Douglas Simmons ran a diversified stock fund at Fidelity it’s pretty clear he wouldn’t overweight the utilities sector. In a recent research report, Simmons methodically ticked off plenty of headwinds for the sector. Alas, Simmons manages the $563 million Fidelity Select Utilities fund. So he’s all utilities, all the time. Investors who don’t have to operate under such restrictive blinders might want to heed some of his caution.

Simmons notes that in terms of price/earnings valuation, the utility sector is anything but a good deal at this juncture. Not only is the sector trading at a multiple well above its long-term average, Simmons points out that (as of the end of Sept.) the sector was trading at a 16% premium to U.S. large caps, when it’s long-term trend is to be in line with the big boys. The S&P 500 currently sells at an average p/e of 13.4. Now take a look at the PE ratio of PG&E (PCG) and Southern Co. (SO).

PCG PE Ratio TTM Chart

PCG PE Ratio TTM data by YCharts

And it’s not as if there’s a strong economic recovery on the near horizon that would suggest higher power demand to drive above-average earnings growth.

The only metric favorable to utilities is of course yield. “Historically, the average dividend yield of the utilities sector has been roughly 25% lower than the average yield offered by BBB-rated U.S. corporate bonds.,” writes Simmons. But right now, thanks to the Bernanke Put that is pushing bond rates to epic lows, many utilities have dividend yields higher than investment-grade bond yields.

US Corporate BBB Effective Yield Chart

US Corporate BBB Effective Yield data by YCharts

Hanging an investment solely on its relative valuation -- on just one metric-is not exactly a recipe for success. If you’re stuck on the higher yields offered by utilities, take a hint from Simmons: he’s focusing on specific stocks that have above-average earnings and dividend growth. Historically, companies with these characteristics have tended to be a significant driver of outperformance in the sector.

In the third quarter, Simmons took a new position in Exelon (EXC) He also added to stakes in American Electric Power (AEP) and FirstEnergy (FE).

EXC PE Ratio TTM Chart

EXC PE Ratio TTM data by YCharts

Of the three, Exelon is the only one to currently earn an Attractive rating on YCharts.

Carla Fried is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.

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