Best & Worst ETFs & Mutual Funds: Utilities Sector

The Utilities sector ranks ninth out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of eight ETFs and 28 mutual funds in the Utilities sector as of April 23, 2013. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figure 1 shows the best two and five worst ETFs in the Utilities sector, and Figure 2 shows the five best and worst Utilities mutual funds. Not all Utilities sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 21 to 78), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Utilities sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings.

My fund rating methodology is detailed here.

Investors should not buy any Utilities ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.

ProShares Ultra Utilities (UPW) is excluded from Figure 1 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

ICON Funds: ICON Utilities Fund (ICTUX, ICTZX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Utilities Select Sector SPDR (XLU) is my top-rated Utilities ETF and American Century Quantitative Equity Funds, Inc: Utilities Fund (BULIX) is my top-rated Utilities mutual fund. Both earn my Dangerous rating.

PowerShares S&P SmallCap Utilities Portfolio (PSCU) is my worst-rated Utilities ETF and Fidelity Adisor Utilities Fund (FUGAX) is my worst-rated Utilities mutual fund. PSCU earns my Dangerous rating and FUGAX earns my Very Dangerous rating.

Figure 3 shows that 51 out of the 135 stocks in Utilities ETFs and mutual funds (over 38% of the market value) get a Neutral-or-better rating. However, no ETFs or mutual funds in the Utilities sector earn a Neutral-or-better rating.

There are not a lot of good stocks in this sector, but there are plenty of bad ones. Unfortunately, mutual fund managers and ETF providers seem focused on the bad stocks. Any fees paid for Utility funds are more than the managers or the providers deserve.

Sources: New Constructs, LLC and company filings

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors should avoid Utilities ETFs and mutual funds, as no fund in the Utilities sector earns better than a Dangerous rating. Investors should focus on individual stocks instead.

Consolidated Edison, Inc. (ED) is one of my favorite stocks held by Utilities ETFs and mutual funds and earns my Attractive rating. That one of the top-rated Utilities stocks has a fourth-quintile return on invested capital (ROIC) of only 5% shows how slim the picking are for this sector. However, ED’s extremely low (4%) cost of capital (WACC) means it is still making positive economic earnings. Add in the fact that ED has grown after tax profit (NOPAT) by 12% compounded annually over the past eight years, and one can see that ED is on a solid, if unspectacular, financial footing. After the stock bottomed in the mid $50s last November, I upgraded my rating from Dangerous to Neutral and saw reduced risk related to the company’s major pension liabilities and questionable accounting related to the pensions. Details on the pension issues are in “Don’t Trust This Utility’s Dividend”.

After reviewing ED’s 2012 10-K in late February, I upgraded the stock from Neutral to Attractive based on strong growth in NOPAT, which enables the company to better address its pension issues. Since I wrote “Don’t Trust This Utility’s Dividend”, the stock’s performance has significantly lagged the S&P and the Dow while growing cash flows at an impressive rate. So, I think the valuation is fairly cheap now.

At its current price of ~$62.37/share, ED’s stock has a price to economic book value ratio of 0.9. This low valuation implies that ED’s NOPAT will permanently decline by 10%. Such a pessimistic expectation is unwarranted for ED. The Utilities sector is generally a stable one, and ED has shown an ability to consistently grow NOPAT. It should have no trouble exceeding the market’s low expectations.

NRG Energy, Inc. (NRG) is one of my least favorite stocks held by Utilities ETFs and mutual funds and earns my Very Dangerous rating. NRG has a bottom quintile ROIC of 2% and NOPAT that has declined by nearly two thirds since its 2008 peak. Debt, underfunded pensions, and minority interests add up to nearly $20 billion in liabilities or more than twice the market cap of the stock. Yes, most investors seem oblivious, as the stock’s valuation is awfully high. To justify its current share price of ~$27.41, NRG would have to grow NOPAT by 8% compounded annually for 28 years. For any Utility company that is an ambitious projection. For a company like NRG with declining returns and major liabilities, betting on such impressive growth is roo risky.

84 stocks of the 3000+ I cover are classified as Utilities stocks, but due to style drift, Utilities ETFs and mutual funds hold 135 stocks.

Figures 4 and 5 show the rating landscape of all Utilities ETFs and mutual funds.

My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 8 ETFs and 28 mutual funds in the Utilities sector.

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.