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Still or Sparkling?

By Ari Charney on January 29, 2016

As value-oriented investors, we don’t like to pay a premium, even for high-quality stocks. In general, if you’re patient enough, the market will eventually give you an opportunity to buy even the most solid stocks at a discounted price.

But some segments of the market, even among stodgy utilities, command a premium to both their peers and the broad market.

That’s the case for the nine publicly traded water utilities in Utility Forecaster’s coverage universe. Right now, their average price-to-earnings ratio (P/E) is 23.0, which is a significant premium to the S&P 500’s valuation at 17.2, not to mention their electric utility peers, at 16.7.

It wasn’t always this way, however. Back during the market’s extended bull run in the 1990s, the relationship that one might expect prevailed: Water utilities traded at a significant discount to the go-go bull market, with P/Es averaging in a range from the high-single digits to mid-teens compared to 21.9 for the S&P.

In fact, it wasn’t until the early to mid-2000s that water utilities’ valuations began overtaking the broad market. Since then, this relationship reset has largely prevailed, with the exception of the market’s sharp rally in late 2009.

To some extent, this reset mirrors a similarly shift that occurred in the electric utility space. The gap in valuations between electric utilities and the broad market narrowed during the mid-2000s, with electric utility valuations periodically climbing above that of the S&P in the years thereafter.

Since hitting an all-time high in late January of last year, electric utilities have seen their valuations fall below the S&P, though they still remain elevated compared to their long-term average.

By contrast, all of the nine water utilities that we track currently trade at or near their 52-week highs, even California Water Service Group (NYSE: CWT), which got pummeled last summer, owing to fears about California’s water crisis.

Clearly, water stocks have benefitted from the flight to safety that began with the dot-com bust, then continued with the Great Recession, and is now occurring once more as deflationary trends upend the complacency of the “New Mediocre.”

Despite the intervening bullish periods over the past 16 years, the stress of each bear market seems to have rewired the psyches of at least some retail investors. After all, they’ve been paying a consistent premium for safety, even when it wasn’t necessary to do so.

Of course, part of that could be due to the fact that sentiment among retail investors tends to lag the market’s big moves. Investors become overwhelmingly bullish at market tops and overwhelmingly bearish at market bottoms. The latter tendency, in particular, can persist for multiple years, even after the market has recovered.

The other factors are demographics coupled with historically low interest rates. The biggest wave of Baby Boomer retirees happened to coincide with a period of extreme monetary easing. The low rates that resulted forced income investors, who would normally allocate a substantial portion of their portfolios to fixed-income securities such as bonds, into dividend stocks such as utilities.

Since they arguably provide the most essential of the essential services, water utilities are well known for grinding out steady dividend growth, making them an especially favored subset of the utility sector.

Lastly, the universe of investable publicly traded U.S. water utilities is tiny. As noted earlier, there are just nine names, all but two of which are small caps.

Put all these factors together and you’ve got a lot of people chasing a very finite number of shares.

We like seeing stocks rise to new highs. But we can’t help but get a little concerned when slow-growing companies trade at a substantial premium to the broad market.

Fortunately, there are signs that the conditions that helped push water utilities to premium levels will likely continue.

Even assuming that the stock market settles down from its current tumult, the Federal Reserve’s long-run estimate for its benchmark federal funds rate is just 3.5%. This indicates that the central bank expects the New Mediocre to live up to the snark implicit in its name.

Meanwhile, as the fiasco in Flint, Mich., underscores, our nation’s water infrastructure is in dire need of upgrading. That’s a strong investment theme that should flow through to water utilities’ future earnings.

Indeed, about 85% of the nation’s population is served by municipal-owned water utilities, many of which lack the capital and expertise necessary to undertake a massive overhaul of their systems’ transmission and distribution pipes.

The U.S. Environmental Protection Agency (EPA) estimates that U.S. water infrastructure requires $384.2 billion in investment, including $247.5 billion for the pipes alone, while our wastewater infrastructure will require another $300 billion to bring it up to current standards.

That presents a huge opportunity for well-capitalized firms such as American Water Works Co. Inc. (NYSE: AWK) and Aqua America Inc. (NYSE: WTR). And it also gives them a visible runway for earnings growth for the foreseeable future.

At the same time, we’d be leery of chasing these stocks higher, especially at current prices. Investors must be disciplined about the price at which they establish new positions.

In this respect, the market’s bad news is our good news. Heightened volatility could give us an opportunity to pick up shares of our favorite water stocks, if not at a discount to the broad market, then at least at a substantial discount to current prices.

When the market plunged back in late August, the nine water utilities dropped as well, and their P/Es briefly averaged 18.5. That may not qualify as the bargain bin, but it’s much cheaper than where things stand now. So set stingy buy limits on a “good ‘til cancelled” basis, and you might get filled at a great price.

In the forthcoming issue of Utility Forecaster, we showed which utilities’ capital-spending plans are giving investors the most bang for their buck. And the water utilities had an impressive showing among the names that made the cut.

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