Seven safe stocks that will last longer than the rally

By Associate Editor David Stevenson Jun 26, 2009

David Stevenson

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Utility stocks have been left behind by the rally. The rally can't last, but utilities will. Buy while they're cheap, says David Stevenson.

At the start of this year, everyone was afraid that we were facing the Great Depression Mark II. Stock prices in many markets fell to levels not seen in ten years or more. But since hitting the lows on 9 March, the MSCI World index is up around 30% and expectations have flipped. The rally has stalled a little since early June, but the prevailing view is that a V-shaped recovery is in store, with the economy and company profits bouncing straight back towards where they were a couple of years ago.

But is that realistic? We don't think so.

In fact, we think there's lots more pain to come. The good news is that amid all the bullishness, a certain group of ‘boring' safe stocks has been almost entirely ignored by the crowds – giving smart investors an opportunity to get in cheap.

We'll get to that in a moment. But why are we unconvinced by the rally? There are several reasons.

First, there's the US consumer. Americans' spending habits account for 70% of US GDP and, in turn, a huge chunk of the global economy. But now they've run out of road.

Retail sales fell 8% in the year to May and have been in negative territory since last September. With US dole queues already at their longest since 1983, they won't be picking up anytime soon.

The unemployment rate has hit 9.4% and even the US president, Barack Obama, sees it hitting 10% this year.

The American housing market – a key driver of consumer spending in recent years – refuses to bottom out. "Prices have been falling for three years, and the decline may well continue for some time," says Yale economics professor Robert Shiller. Deutsche Bank predicts a further 14% drop from here.

The "unprecedented explosion" in debt over the past 25 years, which has raised household debt to double its mid-1980s level, means that "prolonged deleveraging now seems unavoidable", says Paul Ashworth at Capital Economics. "The big danger now is that falling prices and wages will become a permanent part of the economy," says Ashworth, so "the debt-to-income ratio would continue to rise, making the necessary deleveraging harder to achieve. In the worst case, the US could yet slip back into the sort of pernicious debt-deflation spiral that characterised the Great Depression."

Things are no better on this side of the Atlantic. In Britain, retail sales fell 1.6% in the year to May; the jobless rate is at its highest since 1996; house prices are still tumbling; and personal debt levels are even higher than in the US.

Europe faces a potential eastern European loan crisis, which would further hurt already battered bank balance sheets. Even in supposedly stable Germany, the bank rescue fund Soffin has cautioned that deep recession is leading to a "massive sharpening" of bank losses, which would threaten some lenders' capital bases. And Japan's economy is still being hobbled by weak foreign demand for its manufactured goods.

Never mind those old-world economies, you might argue, what about China? After all, much of the recent rally (particularly in commodities) seems to have been based on hopes that China's stimulus package will boost demand across the globe.

"It's clear that markets believe wholeheartedly in the Chinese economic recovery," says Albert Edwards at Société Générale. "Yet nowhere in the world fills me with more scepticism." He ignores the official statistics – "the first quarter 6.1% GDP outturn is simply a lie" – pointing to the 3.2% fall in May's electricity output as a much better sign of what's really going on. Chinese foreign shipments also fell a record 26% year-on-year last month. "In a few years' time," he says, "I believe we'll look back on the Chinese economic miracle as the sickest joke yet played on investors."

With all these headwinds to worry about, it's little surprise that markets took a knock this week after the World Bank downgraded its already bleak view of the global economy's prospects for 2009. And if the economy fails to pick up strongly, firms can't expect profits to rebound either – companies across the world may well have to slash prices as they struggle to maintain sales. That in turn would demolish analysts' optimistic profit forecasts.

Cyclical shares have driven the rally

That's bad news for global equity markets – particularly because the stocks that have driven the recent rally are the ones most geared to an economic recovery, such as basic resources and machinery companies. According to Axa Investment Management, shares in such cyclical stocks have been trading at their highest relative valuation compared with defensive stocks since the start of Axa's data set in 1995. This isn't likely to last, Axa analyst Charles Dautresme tells Bloomberg. "Cyclicals rebound when investors anticipate profit increases, but we're still in a period of downgrades. This move has been too early."

But while you should avoid cyclicals, defensives are a different story.

European defensive shares "have suffered a brutal derating, from a 70% premium to cyclicals – on a 12-month forward price/earnings (p/e) ratio – relative to a 20% discount within a few months", says Citigroup's European equity strategy team. Now "defensives look cheap in absolute and relative terms. Earnings are likely to remain relatively stable, while balance sheets are generally strong."

So although a broad market slump could hit almost all shares, defensives have enjoyed very little of the rally's upside and thus should in turn avoid most of the downside. And their decent dividend yields mean you are being ‘paid to wait' in the meantime. Within the defensive arena, one sector stands out as a must-have – utilities.

Utilities are cheap as chips

A good starting point when looking for the right investment is to seek out a sector that's been largely overlooked by investors. Right now, utility stocks certainly fit the bill.

The MSCI World Utility index has fallen by 14% relative to the overall MSCI World index since that 9 March low. That's left utilities trading at their cheapest valuations relative to the MSCI World index since 2004.

Utilities have been out of favour because they don't depend heavily on economic growth for their profits – people still need energy and water, even in a downturn. They're now "luring investors with the highest dividends since 1995 and the prospect of outsized gains when economies recover", say Christine Lenzer, Adam Haigh and Eric Martin of Bloomberg. Many global utility stocks now yield 5% or more – almost double the level seen at the end of 2007.

That looks a good bet against returns on cash and also compares very well with government bond yields in both America and Britain of between 3.7% and 3.85%. And it looks especially attractive when you realise that for the 14 years up to 2009, the average utility stock yield was actually 1.74% below that paid on top-notch sovereign debt, says Bloomberg data. The average utility has also hiked its dividends per share every year since 2001. That's longer than any other industry group, except healthcare companies – and those firms yield some 40% less.

Better yet, judging by past experience, utilities aren't just a safe haven in weak markets. They've done well in bull phases, too. During the five years to the market's last peak in October 2007, utility stocks rose by 194%, compared with a 139% gain in the MSCI World index, says Bloomberg. Add in dividends, and utility stocks returned 257% over the period – 89% better than the wider index. 

"I like utilities because of their defensive earnings pattern and strong cash generation, and because the sector is not very popular among investors," says Markus Steinbus at Pioneer. "Valuations aren't expensive, the dividend yields are generally considered secure, and it's a way of making a decent income without missing the upside," agrees David Levine at US asset management group Neuberger Berman.

Which utilities should you buy?

A month ago our May Roundtable highlighted UK electricity and gas network operator National Grid (LSE: NG/). Since then the share price has slipped slightly. It now stands on a p/e of 9.5 for the year to 31 March 2010, and yields 6.9%, which is set to rise to a tempting 7.5% for the following year. Centrica (LSE: CNA), Britain's biggest energy supplier, is also worth considering. It's a little more expensive than National Grid, selling on a p/e of around 11.5 with a yield of 5.4%. Since 9 March, its shares have underperformed the FTSE 100 index by more than 20%. However, the group has upped its payout for at least the past nine years, and the near-5% dividend rise forecast by City analysts for next year would lift the yield to 5.6%.

Stephen Bland of The Dividend Letter newsletter likes United Utilities (LSE: UU/). Last year this northwest-England-based water distributor pulled the plug on its electricity business and repaid a large chunk of capital to shareholders. That hasn't stopped it undershooting the FTSE 100 by more than 17% so far this year. United is now on a p/e of nine, and yields 6.7%, forecast to rise to 6.9%.

Those yields are impressive, but you shouldn't just limit yourself to Britain – utilities are cheap worldwide. And while buying overseas exposes you to currency risk, it also gives you some diversification out of sterling. That's not a bad idea, given the UK's precarious finances. In France, the world's second-largest utility, GDF Suez (FP: GSZ), which generates and distributes electricity, natural gas and renewable energy, trades on a p/e of 11.5, with a 6.1% forecast yield for 2010.

German power generator E.ON (GY: EOAN) is even cheaper on a 2009 p/e of 9.6 and a forecast 8.5 for next year. Again, the yield is high, with 5.8% predicted for this year rising to 6.2% for 2010. Even cheaper is Italian group Enel (IM: ENEL), on a current year p/e of below eight and a forecast yield of 7.5%.

The more adventurous, should look to Brazil. In March we said that the country's largest private electricity group, CPFL Energia (NYSE: CPL), was in a unique position to lead the consolidation of Brazil's electricity industry. Thus far – like most other utilities – the shares have done very little. But on a forecast p/e of ten for 2010, and a whopping forecast yield of 9%, we doubt it'll stay that way.

This isn't an exhaustive list, but it does cover some of the best opportunities in the utilities sector. Of course, it's a good idea to spread your risk between sectors. So for several other high-yielding defensives whose dividends should be secure, see: Five high-yielding defensive stocks to buy now

Published in Tips & advice | More articles by David Stevenson

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