Buying weakness and selling strength is the hallmark of the professional investor. Successful investors follow this mantra religiously, while their less successful brethren rarely ever buy weakness and sell strength in the stock market.
In fact, consistently struggling investors often do the opposite of the rules followed habitually by winning investors.
The reason for this fact is simple. It is because it is difficult to buy weak stocks. It is much easier to buy stocks that are “hot” at the moment and moving higher.
This is despite research and real life evidence making it very clear that much higher returns are gleaned from buying stocks that are trading lower. Buying stocks that are trading in the discounted value zone is how professional investors build winning portfolios.
The Opportunity
Right now, the utility sector is trading at a relative discount creating buying opportunities for savvy investors.
The Utilities Select Sector SPDR ETF, which tracks the utility sector, was trading around $44.50 per share in mid-May. It has fallen just under 10% to the $41.50 per share zone currently. The ETF was trading above $49.00 per share at the start of 2015, representing a nearly 20% decline this year alone!
Interest rate fears are the primary reason why utilities have sold off.
Dispelling Utility Myth 1.
Traditional wisdom teaches that utilities behave similar to bonds in their relationship to interest rates. In other words, rates go up, utility share prices fall. However, like most traditional stock market wisdom, it isn’t always the case.
Right now interest rate increases are on the forefront of investor fears. Remember, the falling interest rate environment is not a new phenomenon.
Interest rates on the 10-year treasury have been falling for 30 years. They are now starting to click higher. Since the start of the year, rates on the 10-year treasuries have climbed 17%. This fear has resulted in the discounted selling price of utility stocks.
As in most things stock market related, the fear of the climbing rates has much more impact on price than the actual occurrence. Perception and fear are more powerful than reality when it comes to the stock market. The same effect can be seen in the buy the rumor, sell the fact phenomenon in the financial markets.
Let’s take a look at what happened back in 2004 when the Federal Reserve started to bump up interest rates.
Interest rates were bumped higher by one quarter percent at every Fed meeting. This action was met by the S&P 500 utility index climbing 32% during the first year of rate hikes. When compared to the 8.2% advance of the overall S&P 500, it represents outstanding performance.
In fact, it is questionable if the Fed will raise rates at all this year. Although they are strongly signaling that the rate increase will start in September, a variety of economic pressures could delay the inevitable into 2016. These pressures include the Greek economic crisis, disappointing U.S. job growth, and even China’s growth slowdown.
The bottom line is when interest rates start to inevitably climb, the Fed has assured the markets that the increase will be controlled and the increase will be slow.
History has made clear that when interest rates start to climb higher, utilities will likely begin their advance. Now is the perfect time to get positioned in the sector.
Dispelling Utility Myth 2.
Traditional stock market wisdom also teaches that utilities are boring investments. Sure they generally throw off a steady dividend yield, but they lack volatility therefore are a very slow and steady investment. In fact, utilities are often called the perfect stocks for widows and orphans due to this inherent lack of volatility.
Well, once again, stock market reality reveals that traditional wisdom is not always the case.
A CBS Money Watch article by BAM Alliance director of research Larry Swedroe, citing Dartmouth Professor Kenneth French’s data, made clear that utility stocks may actually be more volatile, as a whole, than the overall stock market.
Swedroe explained,
“For the 85-year period 1927-2011, the total stock market provided an annual average return of 11.6 percent, with an annual standard deviation of 20.5 percent. Utilities produced a slightly lower annual average return of 11.3 percent, but were actually more volatile than the overall market. Their annual standard deviation was 22.2 percent a year. By comparison, the standard deviations of one-month, five-year and long-term Treasury securities were just 3.1 percent, 5.7 percent and 9.8 percent, respectively. As further evidence, consider the following:
- There were 16 years when utilities lost at least 10 percent, including eight when they lost at least 20 percent.
- Utilities generally have their worst years when the overall stock market is doing poorly. As recent examples, utilities lost 23 percent in 2002 and 29 percent in 2008.
There are other important points to consider. While many think of utilities as relatively safe investments (their high standard deviation should be enough to change that view), they can even go bankrupt, as PG&E did in 2001.”
Now that we have dismissed the interest rate and low volatility myths, let’s take a closer look at a utility stock that makes sense right now.
Duke Energy (NYSE:DUK)
Duke is among the largest utility companies in the country. It provides electricity in Florida, North and South Carolina, Ohio, Kentucky, and Indiana.
Share price has been declining over the last six months but has just bounced from the lows creating an ideal technical buy point for bargain-hunting investors.
I like the fact that Duke is actively restructuring itself to improve shareholder value. It is selling off competitive business assets and has launched strategic growth initiatives to build a renewable energy generation business.
In addition, the company has set out to invest up to $4 billion in green energy projects including solar, biomass, and natural gas. The most exciting part of this transformation is the plan to convert its coal field plants to natural gas plants which will ramp up its asset base.
The company is using the proceeds from its sale of its non-regulated Midwest assets to buy back shares, repay debt and strengthen its financial position overall. A true win-win for everyone.
Even more bullish is the fact that Duke plans to access unremitted international business earnings in the next 8 years. This cash will enable the company to aggressively pursue its expansion goals with full coffers.
Add in the fact of the consistent 4% plus dividend yield paid quarterly and it paints a very compelling picture for the company in the $73.50 to $74.00 per share zone
The Key Takeaways
Buying weakness and selling strength is the mark of a true professional investor. Testing and real life prove this to be the case.
Average investors don’t do it because it is difficult to buy weak stocks. It is much easier to purchase hot stocks that are climbing higher.
Right now, the utility sector is trading sharply lower due to the fear of rising interest rates. Fear is a much greater motivator in the stock market than reality. If history repeats itself, once rates start to climb, so will utility stocks.
In 2004, the Fed started a rate increase program. Utility stocks soared during the year that the rate increase started. We are expecting the same thing to happen again.
In addition, utility stocks are often believed to be less volatile and boring than other stock market sectors. Research has shown that, over time, utilities can be even more volatile than the overall stock market.
Our favorite utility stock right now is Duke Energy. Duke’s shares have set up to be an ideal buy at the current price zone.