Utility stocks go from red hot to red flag

NEW YORK (Reuters) - The stock market regularly gets caught up in curious fads. One month it's Chinese Internet stocks, the next it's solar energy producers, and the next it's daily-deal sites like Groupon.

But maybe the most unexpected fad of 2011: utilities stocks. The plodding, reliable electricity companies that your grandmother has had in her portfolio for half a century? They caught fire, thanks to investors' taste for safety and stability in an uncertain world. In fact they were the best-performing sector last year: Utilities funds were up 8.7 percent, according to fund-tracking firm Lipper, a Thomson Reuters company, crushing a flat S&P 500.

That outperformance is likely over, since utilities are now in the unfamiliar territory of trading at a hefty premium to the market. In terms of price/earnings ratio - the common investment metric that divides a company's stock price by its earnings-per-share - utilities are trading at a pricey average of 14, well above the S&P's 12.2.

Historically, by contrast, utilities have been valued at a significant discount -- 26 percent -- to the market. That is because they operate in a highly regulated niche, and offer investors less growth potential as a result. Would-be buyers should proceed cautiously.

"Utilities stocks were red-hot, but the public needs to know the tide has turned against them," says Alec Young, global equity strategist for S&P Capital IQ. "It's an untold story, and there hasn't been enough coverage of it."

Young's rationale: During recessions, utility stocks are investors' favorite refuge, offering an attractive mix of stability and yield. But as the economy shows signs of improvement - GDP growth is decent, jobless claims are down and Europe doesn't seem to be heading off a cliff - it looks increasingly like an American recovery is taking hold.

When the economy improves, counter-cyclical stocks like utilities tend to lag. That's what happened in post-financial-crisis 2009, when utilities inched up less than 8 percent, while a growth sector like information technology shot up almost 60 percent.

It appears that big investors are thinking along the same lines. When Citigroup chief equity strategist Tobias Levkovich recently polled clients about which sectors they least favored for 2012, utilities were at the top of the list. Almost a quarter of those surveyed expect utilities to be the biggest dog for the coming year.

"Utilities already had a very strong 2011," Levkovich says. "Meanwhile, the economic data has been improving for more than six months. The market has started to move, and investors have cash that they want to allocate to the market. So tactically, you're going to get more juice out of more aggressive investments when the market is going higher."

Which isn't to say that you should shun the sector altogether. Even if you shouldn't necessarily be buying utilities at such lofty valuations, your current holdings can still serve as useful ballast for your portfolio, if sovereign defaults rock the market or some black swan sends investors fleeing for safety. That's why Levkovich remains neutral on utilities, even after their blistering fourth-quarter run. After all, the sector does offer an average yield almost double that of the S&P 500.

"I do believe that dividends matter, particularly for aging boomers who need income," he says. "They don't want to dip into their principal, and bonds are offering such low yields, whereas high-quality stocks with a 3-4 percent yield give you nice income and appreciation potential as well. I don't think you abandon dividends in this environment."

One solution is to be highly selective in your picks, since some utilities are more richly valued than others. Despite the gathering clouds for the sector, analyst Justin McCann at S&P Capital IQ identifies prominent names like Exelon, NextEra Energy and Public Service Enterprise Group as stocks to buy.

But be cognizant that the shift away from utilities has already begun. Year-to-date, the sector is down almost 4 percent, lagging the S&P 500 by over 8 percentage points. Part of that dismal performance is thanks to year-end "window-dressing," says S&P's Young. Fund managers saw that the sector was catching fire in 2011, bought utilities stocks to ride that momentum and appease shareholders, and are now starting to unload those positions.

Throw in a recovering economy that favors growth stocks, and sectoral earnings that are actually expected to decline in 2012, and it is not a recipe for continued gains.

"The macro picture is improving, and we're past the point of maximum fear," says Young. "Now there will be less focus on yield and capital preservation, and more willingness to speculate. All of that is bad news for utilities."

(Editing by Beth Pinsker Gladstone and Andrea Evans)