Utilities investors: proceed with care

By Euan Stuart Dec 12, 2005

Utility stocks, much derided in the high-tech boom of 2000, and shunned by investors chasing a quick buck in biotech or resources stocks, have had a splendid few years since. And that's a trend that appears to be continuing this year, says Lex in the FT: so far, defensive sectors, such as utilities and tobacco, have been the stars of the FTSE, while cyclicals, such as general retailers, have been the dogs. It is the same story in the US, says Andrew Bary in Barron's. Over the last year, risk-adverse, yield-hungry investors have pushed the price of utility shares up a full 40%.

The lure of a strong and steady dividend stream is bringing European investors out of the woodwork too, says Paul Betts in the FT. The French are floating their national gas utility, Gaz de France, at the end of the month and the Italians are selling off another tranch of electricity utility Enel. Both offerings look like they'll be sellouts. Still, buying into the sector isn't just about yield. The fact that the world's most famous investor, Warren Buffett, appears to be enamoured of it certainly adds to the attraction. The legendary American investor's existing US electricity company, MidAmerican, is buying Scottish Power's PacifiCorp for $ 9.4bn (£5.1bn), says Michael Harrison in The Independent. That compares with the $ 10.3bn that ScottishPower paid for the West Coast-based utility in 1998. Buffett said PacifiCorp fitted its portfolio 'perfectly' and that he is interested in buying more utility companies, including UK water and electricity firms. 'The bigger the better.' Meanwhile, merger and acquisition activity is picking elsewhere in the sector too, something the analysts say makes the 'bull case' for the sector even stronger. Among the biggest deals on the horizon in the US are Exelon's Public Service Electric & Gas and Duke Energy's acquisition of Cinergy.

But is buying in such a good idea at this point? Andrew Bary isn't so sureUtilities have long been prized as defensive plays in rocky markets because of their 'modest' valuations, but as Bary points out, the average US electric utility now trades for more than 16 times projected 2005 profits. That's no cheaper than the average S&P 500 stock. Nor are current dividend yields that juicy any more, coming in at 4% or less. Don't forget that utility stocks tend to behave a little like bonds ­ if interest rates keep rising (as it seems they will in the US), their yields look less attractive and their stock prices fall. With prices high and yields 'unexciting' why buy?

Why indeed? Especially, as Philip Coggan points out in the FT, as there is 'tentative evidence that the balance of power' in the markets is shifting away from value investing (looking for shares that are cheap on a valuatiobasis) and towards growth investing (looking for companies whose profits or dividends are likely to rise substantially in coming years). According to Dresdner Kleinwort Wasserstein, buying high yield, rather than low yield, stocks ('a classic value approach') was one of the worst-performing investment styles in June. Buying based on price momentum or high-earnings momentum, on the other hand, was extremely successful. This all makes complete sense ­ with growth stocks trading on their lowest price premium to value stocks in 15 years (according to State Street Global Markets), it is surely time for a style change. The bull market in utilities may not be over yet, but utility investors should proceed with care.


Published in Tips & advice | More articles by Euan Stuart

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