Two water stocks to buy now
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Associate Editor
David Stevenson Nov 27, 2009
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Water is now much more attractive
Water utilities have been among the worst-performing stocks in the FTSE since the rally kicked off in March. But suddenly they're looking a lot more attractive. And it's all thanks to the regulator, Ofwat.
It's Ofwat's job to "make sure your water company provides you with a good quality service at a fair price". Back in July, the regulator had threatened a real squeeze on the prices that water suppliers could charge, which hit the sector's shares hard.
But yesterday Ofwat softened up its proposals. And that's resulted in a fine opportunity to buy some bombed-out water stocks on generous dividend yields…
Ofwat has handed investors a fine opportunity
If you've been facing the horrors of flooding this week, the last thing you'd want to think about is paying for more water. But for shareholders in water utilities, the level of prices that suppliers can charge has been a major bugbear over recent months.
Every five years, Ofwat sets limits on the prices that water and sewerage companies in England and Wales will be able to charge their customers. The process for deciding what'll happen to bills between 2010 and 2015 began earlier this year.
Even before anything major had been announced, investors had become jittery that bad news might be on the way. So shares in water suppliers had already started lagging the overall market, while yields in the sector had climbed to above-average levels to reflect the higher risks involved in holding the stocks.
Then in July, Ofwat published draft proposals that would have meant a 'real' (i.e. adjusting for inflation), cut of around 4% in average household water bills over the five-year period.
Of course, a cut in bills means lower profits for water suppliers. And this was a much bigger cut than the market had been expecting. It immediately raised fears that company cash flows would be hit, and so dividends - which are probably the main reason why most people buy utility stocks - would have to be cut. So stocks fell even further.
But was this complete doom and gloom ever justified?
Why Ofwat can't cut bills too sharply
Actually, no. Because the other side of the coin is that Ofwat needs water suppliers to invest lots of money to get the distribution systems - the plumbing, basically - working better. That's very important given the age of parts of the network.
More than 40% of London's water mains have been in use for over a century. Around 20% or so have been around for more than 150 years. That means leaks are a big problem. And if the water suppliers' cash flows are squeezed too hard, it won't just be the shareholders who'll suffer through lower dividends - the pipes will get neglected too.
If that happened, Ofwat wouldn't look too clever at all. Indeed, yesterday's announcement from the regulator suggests that July's statement was just a classic piece of sabre rattling. Now the Ofwat recommendation is for an overall 2010-2015 real-terms price cut of around 1% - so about a quarter of the July proposal.
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And within that global figure, some suppliers will actually be allowed to raise prices in real terms over the five-year period. Meanwhile, companies will be allowed to invest more than was mooted in July, which will boost their long-term returns.
Water companies can now make reasonable money
These numbers still fall short of what the industry was gunning for, but individual firms can still protest if they believe they're being hard done by. But the key point is that this Ofwat submission raises the bar to a level at which water suppliers can make reasonable money. It also means that dividend cuts are now less likely.
So it's no surprise that water stocks actually rose yesterday – even as the stock market overall was thrown into turmoil by the Dubai debt debacle (not to mention an unscheduled shutdown by London Stock Exchange).
But despite yesterday's gains, the water sector is still bombed out. Shares are just a few percent off their lows and still offer some well above-average yields. It's also 'defensive', i.e. water companies don't need much by way of economic growth to make their money.
That should prove very appealing to investors, particularly as concerns grow that the 'V-shaped recovery' we keep hearing about won't materialise. That would lead to disappointing results from cyclical companies (such as manufacturers and commodity producers, which depend on decent economic growth for their earnings), which would in turn hammer their share prices.
The two water stocks to buy now
In contrast, the stock prices of water suppliers should be protected by their high yields, even if the overall market does drop. So which water stocks should you buy? A month ago in Money Morning, reckoning that the sector might come back into favour following the Ofwat decision, we recommended a couple of water related shares.
These were international water utility Severn Trent (LSE: SVT) and sewage and waste management operator Pennon Group (LSE: PNN). Both have risen by around 7% since then. But they still look good on current year yields of 6.7% and 4.5%. With less risk to the Severn Trent dividend than before, analysts are now pencilling in just a 5% cut in the payout for the following year. A 6.3% ongoing yield looks pretty good to me.
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