3 cheap utility stocks that shouldn't be so

Key Points

• Utility stocks could see a swift benefit amid the escalating conflicts in the Red Sea, and investors could look to the sector's stability.
• Some stocks quickly shine within that space as potential high-growth stories at a discount. 
• Analyst price targets serve to close the loop between theory and practice.

Everyone is worrying about the rising effects of the Red Sea conflict. Most investors will likely see success in following the pop in oil prices through stocks like Hess NYSE: HES for reasons you can see here. You can even look into defense stocks like Boeing NYSE: BA and Lockheed Martin NYSE: LMT on new government contract potentials.

However, information spreads quickly in today's marketplace, which means you need to be three – if not five – steps ahead of everyone else. If conflicts keep escalating and creating instability, the price of oil could soon rise, looking to approach targets set by analysts at The Goldman Sachs Group NYSE: GS.

With a 2024 range of $70 to $100 per barrel, the catalyst for a pop could be here. You need to think about how higher volatility could bring new investment flows into stable sectors like utility stocks, namely those that give a more attractive proposition in the face of expensive oil (think green energy). This is why markets are bullish on Brookfield Renewable Partners NYSE: BEP.

Simple filtering

You can't simply throw a dart at the utility board and expect to be happy with blindly picking any stock in the sector. You need a selection filter. Today's criteria? Growth at a discount seems to be the only thing money likes across the board during times of FED pivot uncertainty.

Because of this, you have to start looking into the sector as a whole and start figuring out which names stand out based on that factor. For today, analyst projections for earnings per share growth in a stock's future, combined with valuations like price-to-earnings and price-to-book multiples, can lead you in the right direction.

The average growth in EPS for the utility sector stands at 6.3% for the next twelve months. This average growth is being valued at a forward price-to-earnings (P/E) ratio of 13.7x, followed by a price-to-book (P/B) multiple of 1.5x. Knowing what you know now, you can use these benchmarks to find where the bullish outliers are.

Starting with exclusively selecting discounted stocks, you'll want to look for P/B multiples below 1.0x to ensure the company's 'book' can be bought at attractive prices. Brookfield stock trades at a 0.3x P/B, implying a 70.0% discount to book. Is it justified in the saying that "it must be cheap for a reason?".

Analysts think this stock could grow its EPS by as much as 75.0% in the next twelve months, which is significantly above the 6.3% average for the industry, directly justifying its superior 123.9x forward P/E for an 802.7% premium. The discount on the book has a new reason to play catch up.

These same analysts have agreed on a $31.2 a share price target on the stock, calling for a 22.8% upside from today's prices. Suppose the oil price does not break out due to a Red Sea conflict resolution soon enough. In that case, two other stocks could compensate for the opportunity cost of the sector.

Alternative strategies

Knowing what you know now, it would be helpful to compare the one-year performance between the Utilities Select Sector SPDR Fund NYSEARCA: XLU and the broader S&P 500, which turns out to be a nearly 30.0% underperformance, leaving a lot of room to catch up to the market under the right environment.

Offering a P/B discount despite expecting EPS growth in line with the industry, the initial mix for a potential mispricing opportunity comes from Avangrid NYSE: AGR and Algonquin Power & Utilities NYSE: AQN. These can be bought today for a respective P/B multiple of 0.6x and 0.7x each, but then again, is there a reason why these are being discounted?

For Avangrid, analysts are not too far off the industry's average EPS growth projection, as they have assigned a 9.2% for the stock in the next twelve months. In this sense, there is no absolute reason why the stock should trade at a P/B discount accompanied by a forward P/E discount of 9.6% with its 12.4x multiple.

Adding to the alternative come Algonquin analysts with their 2.0% EPS growth projection, which does fall below the industry average. However, considering that the stock already trades at 65.0% of its 52-week high price, it seems that these projections have one way to go in the next revision: up.

One thing is certain, though: Avangrid price targets are set at $37.3 a shared call for a 20.5% upside from where the stock trades today. Similarly, despite the disappointing growth projections for Algonquin, that stock carries an implied upside of 28.8% in its $7.7 price target set today.