Utilities - time to sell??

Monday, Feb 13 2017 by

Utilities have been fantastic investments over the last 5 years with investors not only rewarded with strong share price performance but also healthy dividend yields. The exception is Centrica which warned on profits and was forced to cut its dividend but it too has recently been showing signs of recovery with a positive trading statement in December 2016. Is now the time to sell or trim holdings in the sector?

Over the last 12 months most utility share prices have flatlined which means they have been underperforming a rising market by around 15-20%. Here are some of the pros and cons:

- an attractive yield premium to the market even after the rise in share prices over the last several years.

- most pledge to raise their dividend at least in line with inflation which is important as inflation is beginning to accelerate

- the yield premium to most other assets is even better. Government saving products like premium bonds,bank account interest rates, cash Isas etc have all been reducing rates of return recently despite rising inflation. Gilt yields have risen slight but are still very low from both a historic point of view and vs. utility dividend yields.

- the sector is a safe haven and one of the few genuinely defensive areas of the market. It was noticeable that the relative high for the sector last year was just after Brexit, the moment of maximum uncertainty. If you think there is going to be a UK recession or there could be an economic or political catastrophe (e.g. Greece not getting its money from the latest bailout) then utilities will do relatively well but will still fall in a bear market.

- the sector continues to consolidate and there will almost certainly be further bids in the future. Last year Dee Valley was taken over by Severn Trent despite a failed protest by local shareholders taking the takeover to a tribunal. The premium was reasonable as it was a contested bid but Dee was already a rewarding investment ahead of the takeover with a decent yield. Pennon might be the next in play with water stocks more likely to be taken over than electricity stocks.

- Like a lot of other defensive sectors (e.g. tobacco, consumer staples) the sector is not nearly as cheap as it used to be even on a relative basis and despite the slight underperformance in the last 12 months.

- Although the economic risk is less than other sectors there is considerable regulatory risk for both water and electricity companies. As we have seen in the last week the electricity companies have been heavily criticized for raising prices leading to calls for more regulation. If this happened it would lower allowed returns and threaten dividend payments.

-Utilities are often viewed as bond proxies. One of the reason the sector has done well is that interest rates and bond yields have collapsed to historically unprecedented low levels following the financial crisis. Although interest rates have not been raised in the UK yet it could happen soon with inflation rising and the economy stronger than expected. Also bond yields (which reflect future economic conditions) have risen significantly over the last year which means the utility dividend yield premiums have fallen.This is one of the main factors behind the relative underperformance of the sector in this time period.

-There is an opportunity cost of holding this sector in a rising market. If you believe post-Brexit economy will continue to defy the consensual pessimism, as I do, then holding utilities is likely locking up money that could be more profitably invested elsewhere. It is likely that financial and cyclical stocks will be in the vanguard of the best performing sectors in such a scenario with utilities among the worst.

I am optimistic for the UK and the economy and that it will continue to do well despite Brexit. Inflation will continue to rise and with the Bank of England increasingly thinking of raising interest rates the relative attraction of the utility has receded and I would expect further relative underperformance. If you have particular requirement for income the sector is still attractive for its dividend yields but should be part of a barbell approach with reductions in utilities (and other defensive sectors) allocated to cyclicals and financials. I have reduced my utility exposure but it is still quite significant as I need the income being retired. However, I believe capital growth prospects are better elsewhere.

Any thoughts?



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Centrica plc is an energy and services company. The Company's segments include Energy Supply & Services-UK & Ireland, Energy Supply & Services-North America, Connected Home, Distributed Energy & Power, Energy Marketing & Trading, Exploration & Production, Central Power Generation and Centrica Storage. The Energy Supply & Services-UK & Ireland segment includes UK Home, UK Business and Ireland. The Energy Supply & Services-North America segment includes NA Home and NA Business. The Company is engaged in the supply of gas and electricity to residential customers in the United Kingdom, and the installation, repair and maintenance of domestic central heating, plumbing and drains, gas appliances and kitchen appliances, including the provision of fixed-fee maintenance/breakdown service and insurance contracts in the United Kingdom. The Company is engaged in the supply of gas and electricity and provision of energy-related services to business customers in the United Kingdom. more »

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Severn Trent Plc treats and provides water and removes wastewater in the United Kingdom and internationally. The Company provides clean water and wastewater services through its businesses, Severn Trent Water and Severn Trent Business Services. It operates through two segments: Regulated Water and Waste Water, and Business Services. The Regulated Water and Waste Water segment includes Severn Trent Water Limited's wholesale operations and household retail activities, and related support functions. The Business Services segment includes the Operating Services businesses in the United States, the United Kingdom, Ireland and Italy; its renewable energy business, and Severn Trent Water Limited's non-household retail business. The United Kingdom Operating Services provides contract services to municipal and industrial clients, and the United Kingdom Ministry of Defense (MOD). The United States Operating Services provides contract services to community, municipal and industrial clients. more »

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Dee Valley Group plc is a United Kingdom-based water supply company. The principal business of the Company is the provision of water services to customers in an area of over 830 square kilometers, in North East Wales and North West England. The Company supplies approximately 60 million liters of water a day. The Company draws 80% of supplies from the River Dee. The Company operates approximately 10 impounding reservoirs, two river abstractions and two groundwater sources. The Company's subsidiaries include Dee Valley plc, Dee Valley Water (Holdings) Ltd, Dee Valley Water plc, Dee Valley Services Ltd, North Wales Gas Ltd, Energy Supplies UK Ltd, Northern Gas Supplies Ltd, Chester Water Ltd. and Wrexham Water plc. The Company, through its trading subsidiary Dee Valley Water plc, supplies drinking water to domestic and business customers in north-east Wales and in north-west Cheshire. more »

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