Why invest in utilities?

With the FTSE 100 at a record high, and other sectors outdoing utilities on yield as well as growth, it’s a question that investors will be asking themselves. Nigel Hawkins offers some answers.

In recent weeks, despite several profit warnings, the FTSE 100 and the Dow Jones stock market indexes have reached record levels. In the latter’s case, investors’ enthusiasm for the agenda of the new US president, Donald Trump, has pushed it through the 20,000 barrier for the first time in 131 years. As for the FTSE 100, its overall yield now stands below 4 per cent, which begs the question of why investors should hold utility stocks when shares in growth-oriented companies are proving so popular.

Admittedly, some of the stocks that have rallied of late, such as Billiton, were previously very depressed. But the two key attractions of utility stocks, despite the various controversial issues that continue to beset some of the companies, are above-market yields and relative security.

Following the provocative 15 per cent increase in its standard electricity tariff by RWE-owned Npower, arguments about utility prices will assuredly persist. It is also the case that the mild winter is no boon for Centrica, which thrives on lengthy cold snaps during the depths of winter. Yet the yield case remains robust, and helps underpin the share prices of leading utilities.

The prospect of a dividend cut is bound to weigh on some stocks, where dividend cover (the ratio of net profits to the total dividend sum) is thin. SSE’s dividend cover, for example, is just 1.3 or so, which may herald a cut in time. The EU’s most valuable utility, National Grid, also has low dividend cover (around 1.5), but it is regarded as the archetypal defensive stock. Its prospective yield is therefore closely aligned to 10-year bond prices, both in the US and the UK gilts equivalent. If bond yields rise – a very likely scenario under the Trump administration, which supports higher interest rates – National Grid’s yield attractions will be less compelling.

For the two largest quoted water companies, Severn Trent and United Utilities, dividend cuts are unlikely, at least before the next price review which will first impact in April 2020. What’s more, both plan to raise their dividends at least in line with inflation until that date. For income funds, such companies provide reasonably secure – and growing – dividends. The number of defensive equity stocks is now quite small. In the early 1990s, there were 17 quoted electricity companies and 10 quoted water companies, not to mention the water utilities.

The high yielders

For those seeking income on the UK market, other sectors are trading on a decent above-average yield. The most notable are the two oil majors, Shell and BP, once recognised as growth companies benefiting from a soaring oil price. Around a year ago, a barrel of Brent Crude was trading at under $30 compared with over $100 as recently as late 2014. Such a massive turn-around in the oil price has had profound repercussions on oil producers, which must adjust to a radically different pricing environment.

Currently, shares in both Shell and BP yield close to 6 per cent as the market frets about dividend cuts. Shell has not cut its dividend since 1945; the recent rally in the oil price to nearer $60 a barrel should preclude a dividend cut – at least for the moment. Income funds that assume both Shell and BP will hold their dividends for the foreseeable future will find their current yields attractive. They will be compared against market heavy­weights such as National Grid.

But yield is not only the factor driving UK utility share prices. After all, following privatisation, bid speculation became so rampant that all 12 regional electricity companies had been taken out within just four years. And, in recent years, the ranks of the quoted water companies have also thinned alarmingly, with just three of the original privatised water utilities remaining.

Currently, there is some takeover momentum behind Severn Trent, which controversially declined a £22 per share offer in 2013, and arguably behind United Utilities. Severn Trent itself has now acquired Dee Valley, despite some arcane legal wrangling. On the electricity front, SSE looks the most likely bid candidate; it would be hugely attractive to a major player in the renewable energy space.

More generally, the UK stock market is expected to be quite volatile this year, and utility shares will be seen by many as a safe haven. For the remainder of 2017, the market will be driven by a series of key events. They include rising interest rates, the fallout from the new US administration, progress – or lack of it – in delivering Brexit, and a raft of key elections, especially for a new French president and, later on in the year, for an incoming German government. Boring it will not be.

Despite all these distractions, UK utilities will continue to plough their own furrows while income funds will remain drawn to the oft-endorsed attractions of holding defensive stocks in interesting times.