Investing Daily Article of the Week

by Richard Stavros

With more and more utilities trading at premium valuations, now is the time for investors to diversify their portfolios into the sector's higher-quality names.

That's my conclusion after attending the Edison Electric Institute Financial Conference last week, an annual event hosted by the association of investor-owned power companies that gives utility CEOs and their investor-relations teams an opportunity to pitch their stocks directly to the investment community.

At the conference, I was struck by the strange indifference among big investors to the risks within the sector.

This complacent attitude is further evidenced by the fact that many utilities' valuation multiples are converging (See “The Great Convergence in Utility Valuations”), indicating that large fund managers really do not understand the risks in the segment, or have overlooked these risks in a flight to safety.

Indeed, a trader for a multi-billion-dollar fund manager I met with at the conference essentially confirmed this theory, when he observed that large fund managers are blindly buying utility stock indices, with little focus on individual names.

When these funds eventually rebalance their portfolios away from utilities, this will inevitably lead to a shakeout as investors become more selective.

The Great Convergence in Utility Valuations

Source: YCharts

This convergence in valuations has happened before.

In the late 1990s, for instance, a common complaint by utility CEOs was that valuations didn't take into account whether a company was fully regulated, diversified, or a pure-play merchant operator. It wasn't until the Enron debacle, the California Crisis and the merchant overbuild that investors began to fully understand the sector's risks.

This convergence occurred again in 2006. Unfortunately, it was soon followed by the broad market selloff that helped precipitate the Global Financial Crisis.