Utility stocks are stretched(from The Globe and Mail)
Monday, February 3, 2020
6:24 AM
Utility stocks have been soaring so far in 2020. Here’s why it may not last much longer
DAVID BERMANINVESTMENT REPORTER
PUBLISHED FEBRUARY 2, 2020UPDATED 11 HOURS AGO
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Canadian utilities have sailed through fears about the spread of the coronavirus and the threat of declining global economic activity. But the stocks are now approaching a hurdle that could prove more difficult to clear: High valuations.
The utilities sector in the S&P/TSX Composite Index increased 8.5 per cent in January. By comparison, the broader index is up less than 2 per cent since the start of the year after declining 2 per cent over the past seven trading days.
U.S. utilities have also been posting impressive gains. The S&P 500 utilities sector increased 7 per cent in January, even as year-to-date gains for the S&P 500 evaporated during last week’s decline.
Investors tend to perceive utilities as well insulated from economic downturns because consumers and businesses need power through good times and bad.
Right now, investors are growing concerned about the economic outlook – oil and copper prices are down; the Dow Jones Industrial Average fell 604.65 points or 2.1 per cent on Friday; and the yield curve (the difference between short-term and long-term bond yields, which is now negligible) is again signalling a possible recession ahead.
In this sort of environment, investors gravitate toward a sure thing – and utilities fit the bill.
What’s more, utilities are bond proxies: Like bonds, investors hold utilities stocks for the consistent cash they spin out in the form of quarterly dividends. These dividends might not look so attractive when bond yields are rising, which is why utilities sold off at the end of 2018.
Right now, though, bond yields are falling and that’s making the fatter yields on utilities stocks more attractive by the day. The yield on the 10-year U.S. Treasury bond plummeted from 1.92 per cent at the end of 2019 to just 1.52 per cent on Friday. The yield on the Government of Canada 10-year bond fell to 1.275 per cent on Friday.
The rally in utilities stocks actually began at the end of 2018, when bond yields began to decline from multiyear highs. In 2019, the TSX utilities sector tallied remarkable gains of 37.5 per cent, and that’s without including dividends.
The problem: High valuations make additional gains hard to fathom. The estimated price-to-earnings ratio for Canadian regulated utilities is above 23, which is well above the sector’s 10-year average of 17.8, according to CIBC World Markets analyst Robert Catellier.
Last week, he downgraded his recommendation on Fortis, to “neutral” from “outperformer,” given his view that gains ahead will be muted.
“We would continue to hold the shares but are less inclined to add to positions at the current levels,” Mr. Catellier said in a note.
U.S. utilities are looking similarly stretched, and for similar reasons.
“We understand and advocate for the appeal of utilities’ defensiveness in the face of macro uncertainty,” Andrew Weisel, an analyst at Bank of Nova Scotia, said in a note last week.
“However, utilities' recent outperformance seems overdone to us relative to global bond yields,” Mr. Weisel said.
His models suggest that U.S. utilities stocks are overvalued from a couple of perspectives.
One, he calculated that the fair-value price-to-earnings ratio for utilities should be 20.8, based on the S&P 500 valuation, the yield on the 10-year U.S. Treasury bond, credit spreads and expected profit growth of utilities. Yet the actual price-to-earnings ratio for utilities is considerably higher, at 22.5.
Two, he looked at the yields on a basket of central bank 10-year bond yields and estimated that the fair value dividend yield of U.S. utilities is 3.28 per cent. But the stocks he follows in the sector have average yields of just 3.09 per cent after the recent share price rally, implying that the rally has gone too far.
“To be clear, we have no idea how bad the [coronavirus] might ultimately be, nor are we attempting to estimate its impact on economic growth or on markets. We’re simply highlighting that utility stocks have been stronger than bond markets justify,” Mr. Weisel said.
From <https://www.theglobeandmail.com/investing/markets/inside-the-market/article-high-valuations-are-becoming-a-new-obstacle-with-canadian-utilities/>