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Ready for the Utilities Rebound? Here Are the Best Picks

image of electric transmission lines at sunset

The business cycle is dislocating sectors left and right. Just a couple of years ago, it seemed that no matter which one you looked at, they all beat the S&P 500 benchmark. We are getting further and further away from that bullish sentiment these days, as favoritism and allocation preference create undeniable valuation gaps.

One example is found in utility stocks. You can easily see that this sector has not been a market favorite lately, particularly on a year-to-date basis. While the S&P 500 has risen by a decent 9.6% during this period, the Utilities Select Sector SPDR Fund (NYSEARCA: XLU) has underperformed the benchmark by as much as 25.4%.

But sectors that are underperforming the market one year have a tendency to lead the market when it recovers. The same will likely be true of the utility sector. As always, MarketBeat has done the homework to bring you the highest potential names within this ETF so you can beat the market this quarter.

Favoritism in the Making

Looking at where the market values this sector, it can be tremendously helpful to go further into how each stock is valued within the sector. With an average forward price-to-earnings ratio of 15.2x, your job is to find the outliers.

MarketBeat offers an excellent stock screening tool, where you can filter stocks based on the highest PE or lowest PE to spot these sector outliers. Contrary to popular value investment belief, you are looking for those valued above the sector average today. We'll explain more about that later. 

But let's get to the results. Names like Brookfield Renewable Partners (NYSE: BEP) with a leading 90.6x multiple, Southern (NYSE: SO) with a mid 16.1x multiple, and Pinnacle West Capital (NYSE: PNW) with a fairer 15.1x to resemble a match in sector valuation.

Why on earth would you want to pay a premium above the sector for these stocks? Like any other product or service, a marketplace will typically be willing to pay the higher price tag (within reason) when the perceived quality and value justify it. Stocks are no different.

Does the name BlackRock (NYSE: BLK) or Goldman Sachs (NYSE: GS) ring a bell? These 'masters of the universe' have laid out where they are moving their money - and their clients' - into. In short, they prefer to seek securities that offer an attractive yield, beating inflation and the near 5.0% 10-year bonds.

Perhaps this is why markets have shown a preference for these forgotten utility players, with Brookfield offering you a 6.0% dividend yield and a 4.2% and 4.6% for Southern and Pinnacle, respectively; these could be too good to pass up this time around.

All about Growth

Justifying these premium valuations would need another reason besides just a good dividend; since bonds can do the trick today, you should expect a bit of additional upside for taking the risk that comes with owning stocks.

Analysts have come up with a consensus price target of $32.6 a share for Brookfield, which implies this stock needs to rally by as much as 45.8% from today's prices. That's an attractive upside range despite BEP being the most 'expensive' name on this list.

For the rest, analysts have decided to play on the conservative end, not wishing to go against the average market valuation multiples. However, Southern and Pinnacle stand out not in targets themselves but where analysts expect earnings per share to go next year.

While analysts see growth of only 8.8% in Brookfield's EPS, Southern takes the podium with a whopping 11.4% expectation, creating the foundation for double-digit returns on top of the inflation-beating dividend.

Remember, all else being equal, one percentage growth in EPS should translate into a similar price move in the stock. Therefore, Southern has what it takes so far. What about Pinnacle? Saving the best for last, you can expect earnings to jump by nearly 17.0% during the next twelve months.

These stocks have all suffered similar year-to-date declines, underperforming the market averages; now that interest rates (and bond yields) will be higher for longer, most investors will likely pivot into BlackRock's advice and seek high-quality cash flows

These preferences are typically found in 'boring businesses' such as utility companies; therefore, potentially positioning yourself before the tide changes can be highly profitable. You get the opportunity to dab in double-digit upside potential, high yields, and low volatility.

These stocks are termed low beta stocks, considering they all carry a below 1.0 beta. This means that when the S&P 500 makes a move, these stocks will - on average - make a significantly smaller move. Give your portfolio what it needs and add these to your watchlist.

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