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How utility stocks have kept their spark


Rising interest rates and inflation are usually a kill switch for popular utility stocks, but these are unusual times.

The sector is the second best performer in the United States behind energy year-to-date, outperforming the S&P 500 by 15 percentage points through Friday. That leaves utilities stocks trading at nearly 20 times 12-month earnings on average, near an all-time high and nearly a fifth richer than the S&P 500. The last time utilities got such a large premium was during the Covid-19 market panic in March 2020. The stilted sector has generally traded at a slight discount to the broader index over the past decade.

With markets fearing a recession, collecting monthly checks is understandably attractive to investors. Cash-strapped consumers are more likely to give up eating or shopping before they risk a power or gas cut. And, by some measures, utilities look more defensive today than they have in recent years, according to Jay Rhame, managing director of Reaves Asset Management, which manages utilities exchange-traded funds. In recent years, utilities have become much simpler, having sold or created units that are riskier or less tied to their regulated monopoly business. Exelon,

for example, earlier this year created a business unit exposed to competitive electricity markets. CMS Energy sold a banking subsidiary last year.

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However, the recovery of the sector is something abnormal given the macroeconomic environment. Utilities stocks tend not to weather rising interest rates well for two reasons: First, utilities are heavily leveraged, with those in the S&P 500 averaging net debt above five times earnings before interest. , taxes, depreciation and amortization, according to S&P Global Market Intelligence. Second, they are a substitute for obligation. When interest rates rise, utility dividend yields begin to look less attractive relative to Treasuries. At one point during the early 2020 recession, the dividend yield on utility stocks was almost 4 percentage points higher than the yield on 10-year Treasury bills. This advantage is now only 0.17 percentage points.

Also, high inflation tends to be bad news for public services. When inflation begins to drive up overall costs for households, it becomes more difficult to persuade utility regulators to grant higher rates. Regulators are usually appointed by governors or elected, so they are not immune to the sentiments that now drive politicians to blame companies – ranging from oil producers to supermarket chains – for causing problems for consumers.

“Price caps, as seen overseas in the UK and elsewhere, have put a strain on companies’ ability to invest successfully and earn full ROE,” wrote Nicholas Campanella, equity analyst at the Credit Suisse, in a report, referring to return on equity. He added that such moves do not yet seem likely in the United States, but are worth watching. For the time being, however, concern about the destructive effect of inflation on fixed income investments may outweigh the other inflation problem.

“At least with utilities, you get a growing revenue stream. And you would think the utility revenue stream might be better in an inflationary environment than a fixed revenue stream,” Rhame said.

The question is to what extent these flows will be reduced by high interest rates and inflation. Additionally, industry-specific clouds are also hanging over the sector, including lost momentum in Congress for what was widely known as the Build Back Better package, which included incentives to clean energy. The most recent roadblock is the U.S. Commerce Department’s investigation into whether Chinese solar producers are circumventing solar tariffs — a development that could significantly delay new solar construction plans. Since utility returns largely depend on their spending on the grid, delays in spending plans can hamper earnings growth.

While investors seem to be finding new worries around every corner lately, the forces holding back the rest of the market may make utilities look like a hidden gem and an expensive lump of coal for a while. a given time. In a falling stock market, however, those power lines are starting to look strained.

Write to Jinjoo Lee at jinjoo.lee@wsj.com

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