Vanguard Utilities ETF: The Current Low Rate Environment Should Support Its Higher Fund Price (NYSEARCA:VPU)


ETF Overview

Vanguard Utilities ETF (VPU) owns a portfolio of U.S. utility stocks. The fund seeks to track the investment results of the MSCI US Investable Market Utilities 25/50 Index. Despite near-term headwind caused by COVID-19, most stocks in VPU’s portfolio will continue to invest in their capital projects to grow their rate bases and EPS in the next few years. The Federal Reserve’s decision to not increase interest rate at least until 2023 may help support these stocks’ valuations as investors continue to seek quality utility stocks that pay attractive dividends. Therefore, we think VPU’s fund price is well supported. The fund is a suitable choice for investors seeking both capital appreciation and dividend growth.

Data by YCharts

Fund Analysis

Near-term headwind caused by COVID-19 but long-term growth outlook remains intact

Most companies in VPU’s portfolio have been impacted by the outbreak of COVID-19. During the peak of the extensive lockdowns (in April), electricity and natural gas consumptions have been down by about 5-10% depending on the severity and the services territories that these utilities operate. For those who are interested, we have analyzed a few utilities companies in the past few months (Click here, and here to read the impact of COVID-19 on Xcel Energy (XEL), and American Electric Power (AEP), respectively). As lockdown measures relax, we expect the impact to gradually recede. In addition, many stocks in VPU’s portfolio have also initiated cost-saving initiatives in order to mitigate the impact. Most of these companies have not changed or delayed their capital projects and these projects are well-supported by their strong balance sheets. Therefore, their long-term growth outlooks remain intact. These investments should also result in rate base growth, and EPS growth (usually in the ranges of 4-8% annually) in the next few years.

Morningstar Moat Status

Financial Health Ratings

% of ETF

NextEra Energy (NEE)

Narrow

Moderate

13.10%

Dominion Energy (D)

Wide

Moderate

7.60%

Duke Energy (DUK)

Narrow

Moderate

6.50%

Southern Co. (SO)

Narrow

Moderate

5.80%

American Electric Power (AEP)

Narrow

Moderate

4.40%

Exelon Corp. (EXC)

Narrow

Moderate

3.90%

Sempra Energy (SRE)

Narrow

Moderate

3.80%

Xcel Energy (XEL)

Narrow

Moderate

3.70%

WEC Energy Group (WEC)

Narrow

Moderate

3.10%

Eversource Energy (ES)

None

Moderate

3.10%

Total:

55.00%

Source: Created by author

These are stocks that have consistently increased their dividends in the past

As a result of their rate base growth in the past, most stocks in VPU’s portfolio have consistently grown their dividends in the past decade (see chart below). Given their commitment to their rate base growth through capital expenditures, it is likely that most of these stocks will continue to grow their dividends in the next few years.

ChartData by YCharts

Stocks in VPU’s portfolio are trading at valuations above their historical average

Let us now take a closer look at the valuations of VPU’s top-10 holdings. As can be seen from the table below, its top-10 holdings have a weighted average forward P/E ratio of 22.25x. This is higher than the weighted 5-year average P/E ratio of 18.96x.

Top 10 Holdings

Forward P/E

5-year Average P/E

% of ETF

NextEra Energy

30.67

21.61

13.10%

Dominion Energy

22.27

18.75

7.60%

Duke Energy

16.26

17.02

6.50%

Southern Co.

17.67

16.83

5.80%

American Electric Power

20.62

18.47

4.40%

Exelon Corp.

13.05

13.65

3.90%

Sempra Energy

16.92

20.14

3.80%

Xcel Energy

23.92

19.79

3.70%

WEC Energy Group

24.57

20.82

3.10%

Eversource Energy

23.81

19.36

3.10%

Total:

22.25

18.96

55.00%

Source: Created by author

The current low rate environment should support VPU’s valuation as investors search for yield

Although VPU’s fund price is not cheap compared to its historical valuation, one must also realize that the current rate environment is supportive of these utilities’ higher valuations. For more information on how treasury rate influences utilities, we encourage readers to read our previous article on VPU here. As we know, the outbreak of COVID-19 has introduced considerable uncertainties and the Federal Reserve has taken dramatic actions to combat the challenge by expanding its balance sheet through quantitative easing. In addition, the Federal Reserve has also lowered its interest rate to near 0%. These actions have resulted in a dramatic decline in 10-year treasury rate. As can be seen from the chart below, 10-year treasury rate is now at a historic low of only 0.61%.

ChartData by YCharts

Since the Federal Reserve has no intention to increase its rate through 2023, we think the 10-year treasury rate will remain below 1% for a lengthy period of time. In this low rate environment, investors will have no choice but to seek quality defensive equities that still offer good yields. Utilities sector is one area where investors can still find attractive yield with limited risk (since most of their businesses are regulated). Not only that, many of these utility stocks have consistently increased their dividends. Therefore, stocks in VPU’s portfolio should deserve a higher valuation above their historical averages in this low rate environment. At the moment, VPU pays investors with an average yield of 3.2%. This is much higher than the 10-year treasury yield of only 0.61%. Hence, there is likely still room for VPU’s fund price to move higher in this rate environment.

Investor Takeaway

VPU’s portfolio of quality stocks should continue to grow thanks to their capital programs that they plan to pursue in the next few years. We think the current low rate environment will support VPU’s valuation and there may be room for its fund price to move higher. Hence, we think this is a good fund to own for investors seeking capital appreciation and dividend growth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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