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Is the Utilities Sector Overvalued?

With the TSX showing an impressive one-year return of 18% a five-year return of 26% and trading at all-time highs, investors should be feeling nervous. Are valuations getting ahead of themselves or is there room to go higher?

I prefer to answer this question by looking into the different segments of the market and making a case-by-case conclusion, and hopefully finding the areas with the most value.

Let’s now take a look at the utilities sector and delve a little deeper. The utilities index has a one-year return of 10.6% and a five-year return of 5%.

Utilities have been a stable place to go for yield as an alternative to the traditional fixed-income investments, which have seen their yields drop in conjunction with the low interest rate environment that we have been in.

Now let’s look at the economic fundamentals and market valuations to formulate an opinion on whether the market is overvalued or not. From a macroeconomic perspective, the utilities sector still looks good as any rate increases are off such low levels, and as valuations have not gone over the top, as they have in other sectors. Furthermore, this sector is largely regulated, and any rate increase can be passed off to the consumer (with the proper legislation). These stocks are more stable by definition and offer a relatively safe place to be.

Valuations in the sector look fair given the position they are in today.

Fortis Inc. (TSX:FTS)(NYSE:FTS) shares have a one-year return of 8.7%, a five-year return of 32%, and are trading at a P/E ratio of 17 times 2017 expected earnings. It has a dividend yield of 3.74%. Almost 100% of 2016 earnings come from regulated and/or long-term utility infrastructure, which makes it a very defensive name within this space.

While rising interest rates give the stock more competition in terms of places investors can put their money for yield, it is a quality name in the space.

Emera Inc. (TSX:EMA) also trades at a P/E of 17.1 times and has a dividend yield of 4.58%. Emera’s stock is pretty much flat compared to last year, and it has a 33% five-year return. This utility has approximately 90% of its earnings coming from regulated and/or long-term contracts, and it has a target to increase dividends by 8% into 2020.

To sum up, the biggest risk in this sector is the fact that as rates rise, utilities will increasingly be less attractive to income-seeking investors who prefer safer fixed-income investments.

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Fool contributor Karen Thomas has no position in any stocks mentioned.

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