Utility stocks are often thought of as a sleepy sector of the market, but there’s nothing boring about the way that the Utilities Select Sector SPDR Fund ETF (NYSEARCA:XLU) has quietly outperformed the broader market thus far in 2024. XLU has outperformed the S&P 500 (SPX) with a 12.5% gain year-to-date (not to mention a 19.6% gain over the past six months), and it could have plenty of room to run further.
I’m bullish on XLU based on the relatively modest valuations of the utility stocks it holds, the potential ace it has up its sleeve in the form of a long-term increase in electricity usage, its attractive dividend, and its favorable expense ratio.
What Is the XLU ETF’s Strategy?
Launched all the way back in 1998, XLU has grown to $13.3 billion in assets under management (AUM), making it by far the largest utilities ETF in the market today.
According to fund sponsor State Street, XLU invests in an index that “seeks to provide an effective representation of the utilities sector of the S&P 500 Index.”
The utility sector is often thought of as a quiet, staid market segment. Its stocks are mostly prized by conservative investors and income investors who value them for their defensiveness and their typically robust dividend yields.
XLU’s Ace Up Its Sleeve
The normally uneventful sector could have an ace up its sleeve in the form of increasing demand for electricity, thanks to the rise of AI, the buildout of more data centers, and other new technologies like electric vehicles and EV charging stations.
Even the proliferation of cryptocurrency (for example, Bitcoin’s (BTC-USD) proof-of-work consensus mechanism consumes electricity in order to produce new blocks of Bitcoin) plays a role in increased electricity usage. Trends like onshoring and reshoring of manufacturing jobs could lead to increased demand for power as well.
A report from the International Energy Agency (IEA) forecasts that electricity demand from AI, data centers, and the crypto industry could double by as soon as 2026. Meanwhile, a new report from BofA Securities finds that electricity inflation is already at a 40-year high of 8% annualized over the past three years due to these trends.
XLU’s Holdings
One thing to note about XLU is that it isn’t especially diversified. It owns 32 stocks, and its top 10 holdings account for 59.0% of the fund. It’s also worth noting that top holding NextEra Energy (NYSE:NEE) accounts for a fairly large 14.0% of the fund.
Below, you’ll find an overview of XLU’s top 10 holdings from TipRanks’ holdings tool.
In addition to NextEra, additional prominent holdings include other large-cap utility stocks like The Southern Company (NYSE:SO), Duke Energy (NYSE:DUK), Constellation Energy (NASDAQ:CEG), Sempra Energy (NYSE:SRE), American Electric Power (NYSE:AEP), and Dominion Energy (NYSE:D).
An attractive aspect of XLU’s portfolio is that many of these stocks feature strong Smart Scores. The Smart Score is a proprietary quantitative stock scoring system created by TipRanks. It gives stocks a score from 1 to 10 based on eight market key factors. A score of 8 or above is equivalent to an Outperform rating. Six of XLU’s top 10 holdings feature Outperform-equivalent Smart Scores of 8 or above, and Sempra, American Electric Power, and Dominion Energy all boast ‘Perfect 10’ Smart Scores.
Additionally, XLU itself has an Outperform-equivalent ETF Smart Score of 8.
XLU’s portfolio is attractive because it trades at an average price-to-earnings multiple of 17.8x. While this isn’t so cheap that deep-value investors are going to be pounding the table for it, it still represents a real discount to the S&P 500, which trades at 23.2x earnings.
Reliable Dividend Payer
Utility stocks are known first and foremost for their defensive nature and their dividends, so it’s no surprise that XLU is a dividend payer. While its 3.1% dividend yield may not necessarily be high enough to knock anyone’s socks off, it’s important to remember that this is double the yield offered by the S&P 500 (1.5%).
Furthermore, XLU has a long and proud history as a dividend payer. The reliable fund has paid dividends for 24 years in a row and increased the size of its dividend payout for 13 consecutive years.
How Much Does XLU Charge in Fees?
Another advantage of owning XLU is that, like its fellow Sector SPDR ETFs, it features a very favorable expense ratio of just 0.09%. This means that an investor putting $10,000 into the fund will pay just $9 in fees on an annual basis, making it an extremely cost-effective option. Over a 10-year period, assuming the fund gains 5% per year, this same investor would pay just $115 in fees, so the savings of owning a low-cost ETF like XLU really add up over time.
One additional consideration is that, like the rest of the sector SPDR ETFs, XLU gives investors plenty of liquidity, with an average daily volume of 14.9 million over the past three months, unlike some smaller funds that may focus on the utility space.
Is XLU Stock a Buy, According to Analysts?
Turning to Wall Street, XLU earns a Moderate Buy consensus rating based on 27 Buys, six Holds, and zero Sell ratings assigned in the past three months. The average XLU stock price target of $71.75 implies just 0.4% upside potential.
XLU’s Risks
Like all investments, XLU is not without risk. Utilities are well-known to be a highly regulated industry, which can pose challenges to raising prices and increasing profits.
Additionally, several utility stocks have suffered in recent years due to natural disasters and extreme weather in the areas they serve. Allegations of mismanagement in their responses to these disasters could lead to liabilities.
That being said, I view this as a low-probability risk, and if anything, it illustrates the usefulness of taking a basket approach to investing in the sector through XLU, which mitigates single-stock risk.
Lastly, additional increases to interest rates could hamper XLU’s rally, as higher interest rates would make risk-free income from treasuries more attractive in relation to dividend stocks and ETFs like XLU. However, utility stocks have already endured what is likely to be the brunt of rate hikes. Plus, data from CME’s FedWatch Tool shows traders expect the Federal Reserve to leave interest rates unchanged in June and cut rates in September, so the worst of this risk may already be behind us.
The Takeaway: A Defensive Dividend Play with Upside Potential
In conclusion, I’m bullish on XLU based on the moderate valuations of its holdings, its attractive dividend yield and long dividend history, and its cost-effective expense ratio. XLU has quietly been a star performer in recent months. Further, it could have plenty of room to run if there is secular demand growth for electricity thanks to technologies like AI and data centers, cryptocurrency, and electric vehicles.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
