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The Undertaker Speaks

By Ari Charney on April 14, 2017

Sometimes I feel like an undertaker. No, it’s not my perpetually dour demeanor. It’s because as a utility investor other people’s pain is my gain.

And there’s been a lot of pain since 2000. Indeed, utility stocks have had an incredible run for most of the past two decades. And the income investors who depend on utilities have enjoyed the enviable combination of steadily rising dividends and market-beating returns.

The period since 2000 has been marked by two major bear markets and a central bank willing to do almost anything to stave off the threat of deflationary spirals.

As such, utility investors have been the beneficiaries of the sector’s safe-haven status, as well as the fact that utilities continued to pay growing dividends as interest rates headed to historic lows.

Even now that the Federal Reserve is starting to demonstrate its seriousness about raising rates, utilities are still leading the way, with the sector’s main benchmarks outpacing the broad market by about 2.5 percentage points so far this year.

But all good things eventually come to an end. And we would expect utility stocks to face selling pressure later this year as the Fed moves to hike rates at least two more times before it begins rightsizing its massive $4.5 trillion balance sheet.

To be sure, monetary tightening hardly spells doom for rate-sensitive stocks such as utilities. But as interest rates begin to normalize, the market will re-rate the stocks for which it’s willing to pay a premium.

And with yield-oriented equities facing increasing competition from fixed-income securities, we would expect stretched valuations to being reverting to their long-term averages. Thereafter, utility share prices would still appreciate over time, just not at the heady pace of the period since the Global Financial Crisis.

Nevertheless, many income investors who we chat with say they’re largely indifferent to near- to medium-term swings in valuations. They claim all they care about is whether a company can continue to pay its dividend.

At the same time, if their favorite dividend stocks were to quickly correct between 10% and 20%, we think they would care a lot more than they’re willing to admit while times are still good and the livin’ is easy.

Meanwhile, those who came late to the party are in a different situation. They need their portfolios to generate income, but they don’t want to overpay for stocks, especially if they’ll soon be available at better prices.

Reversion to the Mean

Fortunately, the market has already done some of the necessary work of re-rating utility stocks. At times, the Dow Jones Utility Average has traded at a price-to-earnings ratio (P/E) well above that of the broad market. More recently, however, its P/E is around 18.9, which is a moderate discount to the S&P 500, at 21.5.

Even so, utility stocks are hardly cheap. The sector’s long-term average is around 15.4, which means utilities trade at a nearly 23% premium at current levels.

And some utility subsectors trade at even bigger premiums. The 11 pure-play publicly traded gas utilities currently trade at an average P/E of nearly 24, while the nine U.S. water utilities currently trade at an average P/E of 28.3.

Why do these two subsectors command such premiums relative to both the broad market and their electric utility peers?

In the case of gas utilities, over the past two years there’s been a mergers-and-acquisitions spree—we jokingly refer to it as the Great Gas Grab—that’s helped further shrink the already tiny space. Gas utilities are highly sought after because they give electric utilities that are experiencing weak or declining demand a new source of growing regulated earnings.

And with the cost of capital on the rise, some investors are likely betting there will be one last push to pair up. But even those electric utilities on the prowl for acquisitions aren’t going to just pay any price to make a deal happen. So investors who are looking to play this trend need to maintain their value discipline.

At Investing Daily’s Utility Forecaster, our value-oriented approach to selecting pure-play gas utilities has paid off with big capital gains over the past two years. Sure, our stinginess means that we miss a takeover candidate every now and then, but we’d rather stay on the sidelines than pay too much for a company that fails to find a suitor.

Water utilities are an entirely different story. While there’s still significant room to consolidate this highly fragmented sector, that trend seems to have little to do with valuations.

Instead, water is really the only utility subsector that doesn’t face imminent disruption from new technologies. That along with the fact that these reliable dividend payers arguably provide the most essential of the essential services explains why water stocks trade at such high valuations.

That wasn’t always the case, however. Indeed, during the 1990s, water utilities traded at levels commensurate with their status as slow-growing, regulated utilities.

Now that we’ve given you the lay of the utility sector, in our next piece we’ll zero in on one utility stock that even the permabulls on Wall Street believe is too expensive.

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