Utilities Choose Sector SPDR ETF: Headwinds Abound In 2023 (XLU)

The Utilities Choose Sector SPDR ETF (NYSEARCA:XLU) was a superb place to cover in 2022, as utilities and power had been the one sectors that delivered constructive returns. Nevertheless, as we head into 2023, buyers ought to think about a number of headwinds going through the XLU.

First, the utility sector is buying and selling at multi-decade excessive valuations of ~20x Fwd P/E. Second, the utility sector has gone from buying and selling at a decrease Fwd P/E relative to the S&P 500 to a better Fwd P/E, because the market’s a number of has contracted. Lastly, the fund’s largest weight trades at a considerable premium valuation with under common development.

Whereas the XLU should still outperform the market in a risk-off state of affairs, absolute returns could also be more durable to attain in 2023.

Fund Overview

The Utilities Choose Sector SPDR ETF (XLU) is a utilities sector-focused ETF supplied by State Avenue International Advisors (“SSGA”). It tracks the Utilities Choose Sector Index (“Index”), an index that goals to characterize the utilities sector of the S&P 500 Index. The index supplies publicity to electrical utilities, water utilities, multi-utilities, impartial energy producers, and fuel utilities. The XLU ETF has been round since 1998 and has $16.5 billion in property whereas charging a 0.1% gross expense ratio.

Portfolio Holdings

Determine 1 exhibits the XLU ETF’s fund traits. It holds 30 firms with common Value-to-E book ratio of two.23 and Fwd P/E ratio 20.1x.

Determine 2 exhibits the fund’s sub-industry weights and prime 10 holdings. The fund is pretty concentrated, with the highest 10 holdings accounting for 60.5% of the fund’s property and the biggest place, NextEra Power (NEE), accounting for 16.2% of the fund.

Returns

Determine 3 exhibits the XLU’s historic returns. The XLU has generated very respectable long-term returns with 3/5/10 Yr common annual returns of 6.3%, 9.5%, and 11.0% respectively to December 31, 2022.

Though XLU’s returns are under that of the S&P 500, as modelled by the SPDR S&P 500 ETF Belief’s (SPY) returns proven in Determine 4 under, buyers ought to be aware that the XLU has commensurately decrease volatility (3Yr St. Dev. of returns of 19.7% for XLU vs. 21.1 for SPY).

Distribution & Yield

Along with offering strong long-term returns, the XLU ETF additionally pays a hefty distribution. Prior to now twelve months, the fund has paid $2.06 / share in distribution, which equates to a trailing 2.9% yield. Looking for Alpha awards the XLU an ‘A+’ grade for its distribution (Determine 5).

XLU’s distribution is paid quarterly and essentially the most not too long ago introduced distribution of $0.57 was paid on 12/22/2022.

Utilities Was One Of The Greatest Performing Sectors In 2022…

Whereas 2022 was a dismal yr for fairness buyers generally, XLU buyers had been comparatively properly protected because the XLU was considered one of solely 2 sector ETFs supplied by SSGA that delivered a constructive return prior to now yr (to January 4th, 2023).

…However Valuations Are At All-Time Highs

Nevertheless, as we head into 2023, I see some potential headwinds that buyers ought to concentrate on. First, the utility sector total is buying and selling at multi-decade excessive valuations as buyers have rushed to the security of utility shares in an fairness bear market. Whereas valuations can keep at elevated ranges and earnings may develop to scale back the valuation over time, it does argue for warning relating to the sector (Determine 7).

Moreover, whereas utility sector valuations have skyrocketed, the general market’s valuation a number of has contracted considerably prior to now yr, from over 22x Fwd P/E to roughly 17x at present (Determine 8).

Market valuations have contracted as a result of as rates of interest enhance, investor demand a better price of return on shares (i.e. decrease P/E) vis-a-vis the danger free treasury price.

For XLU, the implication is that in 2021, when utilities had been buying and selling at ~20x P/E, they had been buying and selling ‘cheaper’ than the market at 22x. Nevertheless, at present, at ~20x P/E, utilities are buying and selling ‘costly’ relative to the market at 17x.

Lastly, XLU’s largest holding, NextEra Power, Inc., trades at a particularly elevated 36x Fwd P/E, nearly double the sector’s median (Determine 9).

Whereas NEE’s valuation is elevated, it solely has earnings development estimate of seven.8% in 2023 (Determine 10), decrease than the sector, the place analysts count on 9% EPS development for 2023 (Determine 11).

I imagine NEE’s valuation is inflated as a result of its ‘ESG’ credentials, and is probably not sustainable in the long term as renewable energy technology turns into extra commonplace.

Conclusion

Whereas the XLU ETF was a superb place to cover in 2022, as we head into 2023, there are a number of headwinds that buyers ought to think about. First, the utility sector is buying and selling at multi-decade excessive valuations of ~20x Fwd P/E. Second, relative to the market, utilities have gone from ‘low-cost’ to ‘costly’. Lastly, XLU’s largest weight, NEE, trades at 1.8 occasions the sector’s median Fwd P/E a number of, but has earnings development lower than the sector common.

Whereas the XLU should still outperform the market in a risk-off state of affairs, absolute returns could also be more durable to attain in 2023.