THE GENERATION GAP
Mike Nickolini doesn’t need to feel the heat to know it’s summer. The investment product specialist at Boston-based MFS Investment Management gets his season-changing signals from the amount of money moving into utility stocks. Utilities, he says, always do well in July and August, when people are more interested in visiting the lake than their investment portfolio.
Besides wanting to take a break from buying and selling for a few weeks, many scoop up utilities to play it safe. Power companies, telecoms and pipeline operators offer services that people need regardless of economic conditions, not to mention a yield that’s currently beating government bonds. “Most people consider utilities recession-resistant,” Nickolini says. “Whatever happens that day, you still have to turn on the lights when you get home.”
However, for value-conscious Canadian investors, it’s almost impossible to find a good deal north of the 49th parallel. Currently, the S&P/TSX utilities sub-index has a trailing price-to-earnings ratio of 19.75. America’s S&P 500 utilities sub-index is much cheaper, at 13.06 times trailing P/E, while the MSCI European utilities index is even more of a bargain at 9.72. With such disparate valuations, investors with their eye on this sector should consider shopping outside of Canada.
Norman Raschkowan, chief North American investment strategist at Mackenzie Investments, says the Canadian market is pricier because people like the highly regulated environment here. It makes for easily predictable income, with less worry about foreign competition. The yield universe is also much smaller in Canada than in the U.S. and Europe, so inevitably income seekers flock to utilities. As well, Canadians get a dividend tax credit for holding domestic yield-producing companies in non-registered investments, which means many investors don’t bother looking at foreign options.
But now’s the time they should. Besides being cheaper, non-Canadian utilities offer comparable if not better dividend yields than domestic companies. In Canada, the utilities sub-index is yielding 4.63%, while the American utilities index has a 4.26% yield and the MSCI utilities index yields 6.23%.
Not only that, many foreign utilities have a better growth trajectory than their Canadian counterparts. Travis Miller, Morningstar Research’s associate director of utilities, says the best buys are energy companies that are either partially regulated–also called integrated companies–or independent power producers (IPP), which have no regulation. Fully regulated companies can’t raise rates without state approval, so margins grow more slowly, if at all.
Integrated companies are made up of two businesses: providing energy to people, which is usually regulated, and selling energy to other utility companies. It’s this latter business where companies can raise prices and experience growth. Miller says utilities with commodity exposure-companies that own coal mines or long-term supply contracts–are the best buys. As energy prices increase, so do margins. Miller is especially bullish on natural gas utilities, because many expect the commodity’s low price to increase over the next few years. “We look for companies with low-cost generation that can benefit in a bullish power price environment,” he says.
Besides growth, integrated companies and unregulated IPPs pose a better value play than regulated companies. Miller says that on a price-to-earnings basis, regulated utilities are 10% to 15% overvalued, while integrated firms and IPPs are 10% to 20% undervalued. The valuation difference is due to a feeling among investors that regulated utilities are less volatile and more predictable than the others. Nickolini admits that less regulation does present some added risks, but as the world economy recovers, integrated utilities and IPPs will outperform regulated businesses.
For an even better deal, look to Europe or emerging markets such as Brazil, says Nickolini. Although the European economy is hurting, there are still plenty of good–and cheap-companies on the market. “There’s a ton of noise that surrounds Europe,” he says. “The continent at a macro level might be challenged, but we feel comfortable with companies at a stock level.” With Brazil’s GDP growing at 7%, Nickolini says MFS has loaded up on electric power and wireless companies there. Many Brazilian utilities are trading below 10 times forward P/E, and offering 5% to 7% dividends. “You’re getting more growth, and in many cases a better yield, and you don’t have to pay for it,” he says.
Investors do need to be conscious of interest-rate and inflation risk. Utilities are similar to bonds in that rising interest rates usually dampen prices and push up yield. People also buy utilities when bond yields are low, so when fixed income becomes more attractive, investors may sell off their utilities. Paul Moroz, a portfolio manager at Calgary’s Mawer Investment Management, says Brazil’s so cheap because bond yields and inflation are much higher there than in North America, making utilities unattractive.
However, Nickolini says that if investors pick the right companies, higher interest rates won’t have as big an impact as many think. Rates go up when the economy improves, he says, but a strong economy also increases demand for energy. “It would cancel itself out,” he says of the prospect of rising rates and climbing share prices.
Investors have to make sure the companies they’re buying can handle their debt loads. Most utilities carry debt, says Moroz; it’s a capital-intensive business. Make sure the company won’t need to refinance if the economy sours. A debt-to-EBITA (earnings before interest, taxes and amortization) ratio of two to four times is reasonable, he says.
The first thing Raschkowan looks at is the security of the dividend. He wants to make sure the utility is earning more than the dividend it’s paying so there will be no risk of a cut. Nickolini wants to see growth that’s double the benchmark. While not every company he owns has that growth curve, his portfolio overall has reached that goal. In Q1, MFS’s utilities portfolio grew by 10%, while the S&P 500 utilities sub-index grew by 5.4%. Valuations should also be in line, if not lower than the benchmark. His portfolio’s forward P/E was 13.1 times earnings, while the index was 12.9.
If investors just want to own electric utilities, Raschkowen suggests holding no more than 5% in a portfolio, but people can hold between 10% and 15% if they include pipelines and telecom. With the sector providing a decent payoff–Morningstar’s utilities sector index, which tracks U.S. utility companies, has a 5.5% five-year annualized total return and a 4.2% dividend–and a strong crop of reliable, income-generating companies, utilities are a safe bet in any season.
London’s National Grid is a regulated utility that has strong growth prospects
Looking for affordable utilities? Consider these international stocks:
CEZ GROUP (WSE: CEZ)
Prague-based CEZ Group is an eclectic company that supplies power to numerous European countries. With the German government planning to take its nuclear power plants offline by 2022. CEZ Group will likely have to supply even more power to its giant neighbour. It’s trading at 12 times next year’s projected earnings–”not excessive at all,” says MFS Investment Management’s Mike Nickolini–and pays a 5% dividend.
NRG ENERGY (NYSE: NRG)
NRG Energy, a Princeton, N.J.-based independent power producer that sells energy to other companies, has a very low cost and low emissions portfolio, says Morningstar’s Travis Miller. Unlike most utilities, it doesn’t pay a dividend, but with many expecting electricity prices to rise. Miller doesn’t think the lack of income is a problem. “You’re buying it for the growth,” he says. The stock price is US$23, but Miller thinks it should hit $35 in the next three to five years.
NATIONAL GRID (NYSE: NGG)
London’s National Grid is one of the few regulated utilities that has strong growth prospects, says Miller. While it’s based in the United Kingdom, and has 11 million English customers, it also has 3.3 million clients in several U.S. states. The U.K. has one of the more favourable regulatory regimes, says Miller, so the company can usually adjust prices if need be. It has a 6% yield, and the stock price should climb from the US$48 it’s at now to $51, he says.
RWE AG (ETR: RWE)
Essen, Germany-based RWE AG has seen its stock price plummet 32% year-to-date but, says Raschkowan, that’s mostly due the negative sentiment surrounding Europe. “People have gotten too pessimistic,” he says. The fact that it’s located in one of the region’s strongest countries is a plus. Thanks to Europe’s debt problems, the company is cheap, trading at 8.1 times estimated earnings, while its gross yield is 9.4%.
DUKE ENERGY CORP. (NYSE: DUK)
Charlotte, N.C.-based Duke Energy is also a regulated company, but the places it operates in–North and South Carolina. Ohio and Kentucky–aren’t as strict as other states when it comes to raising prices, says Raschkowan. He admits that regulation is an issue, but Duke’s attractive 5.4% yield, reasonable 13.6 times 2011 earnings valuation and growth potential makes it a good long-term buy.
BY BRYAN BORZYKOWSKI