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Defensive Investors Flip On the Utilities Switch

19 January 2016 in Trading Ideas

Key Takeaways

  • With US stock indices down significantly thus far in 2016, the utility industry’s stable profits and revenue streams is now seen by many investors as a possible safer haven against the backdrop of last year’s high-flyers.
  • Motifs mentioned: Utility Bills
  • Stocks mentioned: Apple Inc. (NASDAQ:AAPL), Facebook Inc. (NASDAQ:FB), Southern Co’s (NYSE:SO),  AGL Resources Inc. (NYSE:GAS)

For many stock traders, the new year hasn’t done much for preserving peace of mind.

The S&P 500 has fallen 8% out of the gate in 2016 and is now off nearly 12% from its level of six months ago.

The losses have come across the board, as oil plunges to multi-month lows and a former can’t-miss name like Apple Inc. (NASDAQ:AAPL ) has tumbled 25% since July.

Unsurprisingly, many investors have started turning to traditionally defensive sectors. That, in turn, has given a lift to many stocks that underperformed in 2015 while traders chased the market higher via growth stocks.

Take utilities, for example, which struggled last year as these stocks didn’t offer the profile that could match the year’s big-cap top performers – why waste your time with a stable electricity provider when you could get a 30%-plus return from Facebook Inc. (NASDAQ:FB)?

Utilities also took a hit last year because of concerns that the dividend-heavy sector would be vulnerable to concerns about imminent – and frequent — interest rate hikes. But the industry is now seen by many investors as a safer haven, offering stable profits and revenue streams as concerns mount about what a global economic slowdown will mean for last year’s high-flyers.1 (Facebook, by the way, is down 9% in 2016).

The Utility Bills motif is has slipped 2% in the past month, as the three leading US stock indices have fallen from 8% to 10%.

In the past 12 months, the motif is up 1.8%. In that same period, the S&P 500 has decreased 6.9%.

Meanwhile, fears of quick interest rate raises by the Federal Reserve seem to have subsided. Earlier this month, money manager David Kotok of Cumberland Advisors revealed to Barrons.com that his firm is still overweight utilities because interest rates “will rise slowly.”2

Specifically, Kotok believes that after one or two more hikes in 2016, the fed fund rate will sit at 1% or less come year end. That still means a higher rate environment, and Kotok thinks this will slow down broad stock market returns.

In addition, he’s inclined toward defensive names because the terrorist attacks in Paris and the US and other geopolitical risks suggest “more turmoil ahead that could dampen already weak economic growth.” In addition he doesn’t anticipate robust corporate earnings growth.

The Fed’s recent move to raise rates also played into the thesis for buying utilities offered by Morningstar analyst Travis Miller, who wrote recently that with one rate hike already priced in, “pockets of value have developed” in utilities stocks as many of these firms still have the same strong dividends, balance sheets and growth estimates.3

In addition, low finance costs are “turbocharging” growth in the sector, according to Miller.

He noted that the attractive financing dynamic has led to a half-dozen substantial acquisition bids during the last year, all at “eye-watering valuations.” Deals such as Duke Energy Corp’s (NYSE:DUK) bid for Piedmont Natural Gas Company, Inc. (NYSE:PNY) at 30 times earnings and Southern Co’s (NYSE:SO) bid for AGL Resources Inc. (NYSE:GAS) at 22 times earnings “demonstrate the benefits of low-cost financing to boost long-term earnings growth.”

Miller expects more sector consolidation as long as interest rates stay low.

Miller did caution that his firm expects weak electricity demand and regulatory risk to remain a concern for some utilities in the US and globally. “Diversified utilities and independent power producers with coal and nuclear generation around the globe are struggling as natural gas becomes a cheaper, more environmentally friendly fuel source for power generation.”

Yet until those concerns begin hitting the yields offered by utilities companies, the sector’s attractiveness as a defensive investing alternative may continue – particularly if we get a continued global selloff in stocks.

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  1. Scott Stoddard, “Utility Stocks Find Favor As Investors Turn Defensive,” investors.com, Jan. 11, 2016, http://news.investors.com/investing-ibd-industry-themes/011116-789234-utility-stocks-rebound-as-investors-turn-cautious.htm, (accessed Jan. 17, 2016).
  2. Johanna Bennett, “Top ETF Picks for 2016, According to David Kotok,” barrons.com, Jan. 5, 2016.
  3. Teresa Rivas, “Buy Utilities for Yield and Growth: Morningstar,” barrons.com, Dec. 30, 2015.

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