From the perspective of a long term investor, utilities’ stocks are generally viewed as low-risk and conservative investments (not hot or sexy or trendy). Why?
Utility companies are capital-intensive, tend to operate under government regulations and licensing (which allows them to enjoy oligopolistic/monopolistic features) and provide services that are indispensable to the well-being of a nation. Electric, gas, and water firms fall under this category, and without them, an economy cannot function at all. Thus, they are lowly-correlated to the direction of the overall economy and less sensitive to boom-and-bust cycles, making them ideal as conservative investments to long term investors.
Their defensive characteristics coupled with the relatively-inelastic demand of their products and services (often in large contracts) also allow reliable forecasting of revenues and earnings streams from their various projects, which in turn allows management and financiers to prepare corporate budgeting and financing for their projects and businesses.
However, one unfortunate characteristic about utilities is that they tend to be highly-leveraged – significant infrastructure investments require a high amount of capital that is often debt-financed. This in turns makes utilities’ vulnerable and sensitive to the overall direction of interest rates. They will perform well when interest rates are low.
In the United States, US utility stocks have performed well over the past decade, and companies have benefited from the past 7 years of a low interest rate environment as they took advantaged of cheap financing costs and leveraged up their balance sheets. Their share prices have steadily moved higher alongside US Treasury bond prices, highlighting their ‘bond-proxy’ nature as investors chase yield in a ZIRP situation (as Factset illustrated below).
Utilities also benefit from a ‘safe-haven’ allure due to their defensive characteristics as explained earlier (just like government bonds). Investors, particularly money managers (like mutual fund managers) often shift capital to utility stocks during times of market volatility, using the allocation to utility stocks as a proxy for cash as many institutional mandates have a limit as to how much cash as a % of their overall portfolio assets they can have at any point of time. Thus, when money managers feel risk averse, they tend to look to utilities as a temporary place for shelter.
With a return of market volatility since 2015, it’s hardly surprising that utilities have been one of the best performing sectors in the US stock market. However, prices have been pushed higher and from a valuation perspective, utility stocks as a whole seem to be trading at expensive valuations. As of 3 June 2016, the S&P 500 Utilities Sector Index trades above 21.0 times their 12-month forward earnings estimates’ – a number more fitting for small-cap growth stocks than dull power companies.
Additionally, a recently-released chart from the US EIA indicates that retail electricity sales have been in a long term decline. Either consumers have been using less power, or/and they are more efficient in the consumption of it.
This leaves us with a situation of:
- relatively-stretched and “frothy” valuations – how much further could it go? Would earnings grow enough to catch up and lower multiples?
- a market segment extremely sensitive to higher interest rates (should they ever go up)
- participants all somewhat on one side of the boat, making the segment crowded and vulnerable to rapid sell-offs resembling a herd-like scrambling for the exits (should it happen)
- a lower growth situation as customer demand steadily dwindles (this is bad news as the cost to maintain the grids are the same)
Let’s take a look at the price charts (using the SPDR Utilities Select Sector ETF – XLU):
Prices have been on an uptrend for some time, and have recently broken above a trend-line resistance level as markets repriced a lower probability of the US Federal Reserve raising policy rates this month and in July.
The segment can continue to perform for a while due to investors’ appetite for yield and as the baby boomer generation move into retirement (demanding more from their retirement monies). However, it may not be wise to remain long in the segment given the reasons explained above, which paints a relatively precarious scenario.
Course of action:
A nimble investor could continue to remain long in the segment, benefiting from the still-uptrend in prices, but get out should prices break down. Whereas a highly-skilled trader could bet against the segment should inflationary pressures start to show up through data or policy-makers start to turn hawkish again, causing inflationary expectations to increase, which in turns lead to a sell-off in utilities’ stocks (especially if prices break below the 6-month support trend line as shown in the chart above). One could also benefit from the short side as the herd rushes for the exits, causing further downward pressure on prices.
*I have no market exposure, either long or short, in the segment*