Utilities offer one important thing to investors – reliability. Given the current state of the world, that could look pretty attractive.
It doesn’t make sense to dig up the roads to lay two sets of pipes, sewers or electrical cables, so utilities tend to be monopolies. That means they own most of the market share. Most of us don’t have a choice who supplies our water, and because we can’t live without it we’re forced to pay whatever our local supplier chooses to charge.
Fortunately the problem in this is obvious. As a result governments regulate utilities very heavily. The regulator gets to say how much they can charge, how much they should invest and how much profit they can make. All this regulation, combined with a monopoly position, has made utilities relatively predictable and utility dividends among the most reliable on the market. Although no dividend is ever guaranteed and past income isn’t a reliable indicator to the income you’ll receive in future.
On the other hand, it’s also hard for a utility to grow. Because the capital value of a utility has been relatively stable compared with other stocks, investors often treat utilities a bit like bonds.
Why would you want something similar to a bond now?
Well, the economy is in a fairly tough position at the moment. The pandemic and our efforts to control it have stopped us from spending money on lots of the things we usually do, such as in the hospitality and travel sectors. At the same time, supply chains have been disrupted and lots of businesses have been operating with severely reduced capacity.
Governments have essentially put large parts of the economy on life support, but that isn’t sustainable long term. For example, the UK’s Furlough Scheme is being replaced by a much less generous program in November. We might yet see a further wave of unemployment, which would mean slowing sales, more mortgage defaults and even a full blown recession.
Of course, the economy could also recover smoothly over the next year or so. This could even be the most likely outcome. However, when the situation is this uncertain it might be worth thinking about the more reliable names on the market.
The risks in utilities
If investors are treating utilities like bonds then they should be very sensitive to interest rates. When interest rates fall, bond values should rise. We think falling interest rates explain a large part of why most of the utilities we cover have outperformed the stock market over the last ten years, even before dividends.
Utilities vs FTSE All-Share before dividends
Past performance isn’t a guide to future returns. Source: Thomson Reuters Eikon, 06/10/20.
Interest rates are currently at record lows and it doesn’t look like there’s room for them to fall much further. But, if rates rise investors can expect their utilities to fall in value. The utilities also carry a lot of debt, so higher rates would mean more expensive interest payments, potentially putting cash flow under strain. Interest rate risks look quite one sided at the moment, although whispers of negative interest rates have started to creep back into the investment spotlight again.
The regulatory environment has also gotten tougher, especially in water. OFWAT is demanding lower prices for consumers and has set the lowest allowed return on capital since the water companies were privatised. This means lower dividend growth, and we’ve already seen payout plans get cut back in response. While lower dividend growth is unfortunate, it’s better to have the relative certainty of lower growth than risk a cut in the future.
Lower activity in the economy could also mean lower demand for electricity, especially from businesses. This means the power companies could also be facing challenges.
Finally, more customers might struggle to pay their bills in a recession. While the regulators do make allowances for this, it could still put pressure on the bottom line.
Having said all this, the utilities are still likely to be among the most resilient companies if conditions do take a turn for the worse. Higher interest rates will reduce the value of almost all stocks and a recession will hit earnings at most companies. The value of all investments rise and fall, so you could get back less than you invest.
So is now the time?
Utilities can be good for investors looking for reliable income, especially those worried about the potential of a sustained recession. They’re still likely to be among the most dependable companies on the market. But there are always risks when you invest in stocks, and we’ve outlined some of the most relevant above.
Of course, if everything goes smoothly from here the utilities might get left in the dust by faster growing peers. Nonetheless we think there’s a strong case for including some utilities as part of a diversified portfolio. That way you stand the best chance of doing well whatever happens.
This article isn’t personal advice. If you’re not sure of whether an investment is right for you, seek advice.
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