Absolute Return Investing — Utilities

I’m not an investment snob. To achieve attractive absolute returns over a market cycle, I believe it’s important to keep an open mind and your opportunity set as wide as possible. At times, I’ll be interested in areas some investors will avoid either due to their rigid beliefs or perception fears. There are times during market booms and near cycle peaks that boring stocks, such as utilities, are often forgotten and left behind. In a raging bull market, utilities may be considered too risky to hold for professional investors obsessed with relative performance. Portfolio managers may avoid boring stocks as they try to keep up with the herd, providing opportunity for absolute return investors.

I admit I like utilities. I’ve often used utilities to help generate absolute returns, especially when they’re being neglected by the go-go relative performance crowd. Utilities are simple businesses and mostly regulated. In effect, they’re easy to value. If you can buy a utility near or slightly above book value, an investor can earn near the utility’s allowable (what regulators allow utilities to earn) ROE. Customer growth and the moderate use of leverage can also add slightly to growth and enhance returns further. I often use tangible book value as a starting point in my utility valuations and apply a realistic allowable ROE (adjusted for regulatory lag) to determine the expected cash flow from the utility. I then view it more or less as a perpetual bond with a no to slowly growing coupon.

Near the last cycle’s peak (2006-2007) I was able to find attractively priced utilities which allowed me to soak up some cash in a very expensive small cap market. The herd was avoiding boring utilities in favor of more exciting returns, such as those found in cyclical and commodity stocks. Unfortunately, this cycle utilities are not attractively priced and are not being ignored — utility stocks are on a tear and have been one of the best performing sectors for the first half of 2016. According to Yahoo Finance, Utilities increased 21.2% during the first half of 2016. Select water utilities have done even better with California Water Services (CWT) up 52% and Middlesex Water increasing 65%. So much for boring and forgotten – charts of water utility stocks look like internet stocks in 1999! As mentioned earlier, I prefer buying utilities near or slightly above book value. Currently most utilities are selling at meaningful premiums to book value and significantly over historical price to book ratios. Water utilities are selling near 3x book value on average, which implies P/E ratios near 30x based on allowable ROEs of approximately 9%. These valuations make little sense to me given risks and historical and expected growth rates.

I think most would agree that utility stocks are being chased for yield this cycle, as long term Treasuries yields collapse to 1-2%. As their stocks surge, yields on utility stocks are falling and no longer appear as attractive and defensive. Yields on water utility stocks are particularly unappealing. According to Dividend.com, the water utility stocks in its group are only yielding 2.04% on average, with some water utilities, such as American Water Works (AWK) yielding below 2%. As utility stocks have outpaced gains in long term Treasuries (ETF TLT up 16% first half of 2016), their dividend yields are also becoming less attractive relative to Treasuries.

While investors may point to the collapse in bond yields, especially Treasuries, as a reason to own utilities, lower Treasury yields can increase regulatory risk. Regulators often look to competing yields, especially risk free yields, when determining a utility’s allowable ROE. Assuming interest rates remain depressed, it is within reason to assume regulators may reduce (or continue to reduce) allowable ROEs, which in turn would reduce the cash flows and ultimately what an investor is willing to pay for the business. While lower allowable ROEs and lower rate hikes would benefit utility customers, it would not be great news for utility investors.

In addition to lower yields, I believe utilities have benefited from investors flight into quality. I believe quality is very expensive for this stage of the market cycle. Many investors were burnt last market cycle by piling into riskier cyclical businesses. When the 2008-2009 crash hit, many of these lower quality stocks were destroyed. Investors have learned their lesson this cycle, or have they? While high quality businesses, such as utilities, have more certain cash flows and are less risky businesses, are they lower risk investments? Given current valuations, I do not believe they are. We’ll have a lot more time to discuss the excesses I’m observing in high quality stocks (very important and underappreciated topic), but for now I just wanted to point out that I believe utility stocks were benefiting from the rush into quality.