After a long run, utilities face headwinds
Utility companies show weakness as corporate customers begin producing their own power and climate-change rules take a bite
By: JOEL SCHLESINGER
Date: September 27, 2016
Investing in utilities has proven fruitful for those seeking regular income. In a low-interest-rate world, where bond yields barely keep pace with inflation, investors have flocked to these equities for their steady dividend yields often exceeding 3 per cent.
Consider the iShares S&P/TSX Capped Utilities Index ETF, an exchange-traded fund tracking the S&P/TSX Capped Utilities Index. Over the past five years it has averaged a total return (dividends included) of about 5 per cent a year, and today pays a dividend yield of about 3.7 per cent.
In the United States, the iShares U.S. Utilities ETF has averaged a total annual return of more than 13 per cent and pays a distribution yield of more than 4 per cent.
“On both sides of the border, the sector has benefited from the search for yield, particularly as we have seen government bonds in Europe and Japan go into negative yields,” says Ted Dixon, a securities analyst and chief executive officer of INK Research in Vancouver.
Yet observers are increasingly cautious, warning investors that they could be in for a nasty shock.
“Utilities can be a good source of dividend income for investors as the business is generally regulated, which can provide a high degree of confidence for a positive return,” says Tony Demarin, president of BCV Asset Management in Winnipeg.
But utility stocks also can be interest-rate sensitive “due to their high levels of debt, which are usually supported by long-life fixed assets.” Rising rates can also make the dividend less attractive as interest-bearing securities become more popular, Mr. Demarin says. Given that interest rates are almost as low as they can go, they have few places to go but up.
“While you can’t really say any level of valuation is a magical turning point, what you can say is the expectations baked in the utilities stocks are pretty high right now,” says Roger Conrad, editor of Virginia-based Conrad’s Utility Investor.
Other headwinds are blowing, too.
Briton Ryle, editor of the Wealth Advisory newsletter, recently argued that traditional electricity providers face shrinking revenues, in part because traditional, grid-provided energy use in the United States peaked in 2007. The Great Recession that followed may have played a role in the slow recovery, but Mr. Ryle says another reason could be the increase in large corporations producing their own renewable power.
Utility companies are “slowly losing corporate business,” he says.
In addition, Apple and Google and other companies have applied “to sell electricity that they generate to consumers,” Mr. Ryle says. “They could be essentially competing with traditional utility firms.”
In Europe, large utilities such as RWE AG, Germany’s largest, have lost revenue and shuttered coal and natural gas plants as homes and businesses have installed wind and solar systems. “That’s money taken right out of utility providers’ pockets, and the same thing is going to happen here,” he says.
All of these factors add up, he says. “Clearly, this doesn’t have the same scope as the financial crisis, but I think it could be very damaging.”
In Canada, “there are two Canadian stocks with key insiders selling for every stock that has key insiders buying,” Mr. Dixon says. In the United States, the number is higher, with five selling for every one who is buying.
Some utilities have shown weakness for another reason: a changing regulatory environment. Shareholders in Calgary-based TransAlta Corp, for example, received a jolt after the share price and dividend payout fell in January when the company announced it would incur costs as it transitions off coal to meet climate-change obligations.
Still, investors need not divest altogether. Instead they should hold onto the best stocks in the sector, especially those moving aggressively into wind and solar, Mr. Conrad says.
One company to consider is Virginia-based Dominion Resources Inc. “Dominion is building major facilities for Amazon and Microsoft,” he says, including battery storage infrastructure, which has long been a problem for wind and solar firms. Another leader in battery storage is AES Corp., which is working on projects in California.
Larger solar firms such as Arizona-based First Solar Inc. could also benefit, Mr. Ryle says. “It has a ridiculous amount of cash on its balance sheet, and I think it’s going to start paying a dividend sometime soon,” he says.
In Canada, larger firms such as Fortis Inc., Emera Inc. and Canadian Utilities Ltd. “are well managed, diversified companies with long track records of dividend growth and share price appreciation,” Mr. Demarin says.
But as the long run of falling interest rates continues, Mr. Dixon says the risk builds. “We’re in the early innings,” he says. “There is still time for people to slowly position their portfolio for the risk of rising rates.”
Still, rising rates themselves may not be enough to negatively affect the industry, Mr. Conrad says. During the last tightening period, between 2004 and 2006 in the U.S., “the Fed rate went from one per cent to five and a quarter, but utilities averaged a return of about 60 per cent, about four times what the S&P 500 did.”
Mr. Conrad recommends investors scale back their positions and return to the market when prices are more reasonable, just as his advisory firm has done.
“We’ve taken a lot of profits on companies just on the idea that prices are going to come off,” he says, “and we’ll get a better opportunity to redeploy the cash back into shares.”
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