Riding the FTSE rollercoaster

There are only five utility stocks in the FTSE-100 but, thanks to political and market uncertainties, they are no longer the boring investments they used to be, says Nigel Hawkins.

For investors, the FTSE-100 is the key yardstick for the UK’s leading companies. Membership does rotate, but the changes are generally at the lower end of market capitalisation, currently about £3.9 billion.

Like the football league, the worst performers of the FTSE-100 are relegated to the lower FTSE-250, and the latter’s stars are promoted. FTSE-100 membership is reviewed quarterly and usually there are a handful of changes.

Of course, for the leading FTSE-100 companies, changes at the bottom of the table are hardly noteworthy. Importantly, the UK’s top 10 companies are worth more than £700 billion, way above the approximately £40 billion for the least valuable ten at the bottom.

Top of the pile is undoubtedly Shell. Its two quoted stocks (A and B shares) are currently worth a combined £150 billion plus.

Second up is HSBC, whose operations are predominantly in the Far East, which helped it to avoid the appalling fate that befell RBS that necessitated a £45.5 billion cash injection from the taxpayer.

Shell’s long-time competitor BP, now recovering from the disastrous Gulf of Mexico blow-out in 2010, is currently in third place ahead of Britain’s top drugs company, GlaxoSmithKline, with a current capitalisation of £76 billion.

The market value of the UK’s largest utility, National Grid, is far lower at about £32 billion. Considering National Grid was privatised only as an afterthought through the percentage holdings of each regional electricity company in 1990, its rise has been quite remarkable.

Interestingly, too, given that it has no ­consumer-facing profile, it has avoided most of the political flak that has enveloped the utility sector in recent months.

The same, of course, cannot be said for Centrica after the 18-month price freeze pledged by Labour leader Ed Miliband. Nonetheless, despite its recent tribulations, Centrica remains the UK’s second most valuable utility, worth some £16 billion.

In fact, this valuation is only slightly above that of Perthshire-based SSE, which is facing a raft of challenges ranging from political issues, such as next year’s general election and September’s Scottish independence referendum, to outstanding distribution reviews, fluctuating generation prices and uncertainties about renewable subsidies.

Of the remaining FTSE-100 utility stocks, both are water companies: Severn Trent and United Utilities. Both are currently valued at less than £6.5 billion and, crucially, still have unfinished business with the ongoing periodic review.

Severn Trent has yet to agree several capital expenditure issues, some relating to the Elan Valley water supply system, and Ofwat still has to sign off United Utilities’ massive sewerage investment programme, which stretches out to March 2020.

During a recession, as defensive stocks, utilities would normally be expected to outperform other sectors, as water has done.

However, electricity shares have proved less resilient to the recession, although shares in National Grid – with no significant generation exposure – have been robust since its eight-year UK regulatory settlement.

Most stocks in the FTSE-100 are growth-orientated, with the focus being on annual increases in earnings per share and real dividend growth.

Notable stocks in this category include Vodafone and Rolls-Royce. Both have extensive overseas businesses and have grown impressively over the past decade.

With varying sector performances, fund managers must be particularly alert when adjusting their holdings to reflect likely trends: their assessments should be focused on the future, not the past.

Both the prevailing political and economic environments are obviously key. In recent weeks, continued instability in the Middle East, and especially in Iraq, has led to an increase in the Brent Crude per barrel price, benefiting oil stocks such as Shell and BP.

In moving FTSE-100 share prices, there are three leading factors. First, macro-­economic issues are very relevant. Aside from political factors, interest rate changes – and the expectation of changes – are crucial.

For a highly leveraged company, rising interest rates will push up its financing costs, cutting earnings.

In the case of UK housebuilders – Persimmon is currently the only FTSE-100 representative – the interest rate impact is even more severe because potential house purchasers are also dissuaded from buying.

Exchange rate movements, too, are important, especially for major exporters such as Rolls-Royce, which can be priced out of overseas markets by an overly strong exchange rate. No UK utility, except National Grid, is affected significantly by exchange rate movements.

Second, sector-related stories are also a share price driver. For example, Pfizer’s £69 billion bid (now aborted) for AstraZeneca has powered the pharmaceutical sector.

In the utilities sector, the periodic review is crucial for all water companies, and Miliband’s energy price freeze pledge has been particularly targeted at Centrica and the other ‘big six’ energy companies.

Energy companies also face various sector-related issues, ranging from the forthcoming Competition and Markets Authority’s inquiry to fluctuating power prices and doubts about the durability – and level – of renewable energy subsidies.

Third, individual company share prices are highly dependent on the latest results, with profit warnings producing the most notable downward movements.

Previously, Cable & Wireless was notorious for issuing numerous profit warnings – a role now usurped by Carpetright. But the effect of profit warnings on share price, such as that from Tesco in January 2012, can be very damaging.

Of the regulated utilities, Centrica is probably the most exposed in this respect – as May’s profit warning, arising from mild UK weather and extreme weather in the US, demonstrated.

In fact, the five FTSE-100 utilities represent a relatively small component of the total FTSE-100 value. Even if BT and Royal Mail – utilities in many investors’ eyes – are included, the value of these seven stocks is currently just under £110 billion.

Significantly, several European stock exchanges were dominated for many years by shares in banks, power companies and telecoms. However, failing banks, falling power prices and lacklustre telecoms returns have recently curbed this dominance.

Given utilities’ relatively low overall weighting, UK fund managers do not necessarily feel obliged to be heavily exposed to them; many, though, choose to do so, especially in respect of National Grid.

How the next two years will pan out in terms of the performance of the five FTSE‑100 utilities compared with the FTSE‑100 remains to be seen. In view of the many issues affecting the former, it is likely to be a rollercoaster ride – hardly matching the perception of the traditional boring utility.

Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research