Ten Days That Shook the World. Since the Election, Utilities Have Underperformed by 8.1%: Are Utilities a Buy, or Is Worse to Come?
Eric Selmon Hugh Wynne
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November 17, 2016
Ten Days That Shook the World.
Since the Election, Utilities Have Underperformed by 8.1%:
Are Utilities a Buy, or Is Worse to Come?
The first ten days of Trump have seen the yield on the 10 year U.S. Treasury bond rise by some 40 basis points and the Philadelphia Utility Sector Index (UTY) of predominantly regulated utility stocks has underperformed the S&P 500 by 8.1 percentage points. Since its peak on July 6, the UTY has underperformed the S&P 500 by 16.6 percentage points. Is the correction behind us and are utilities a buy? Or is worse to come?
Much will depend on the effectiveness of the Trump administration during its first year in office. Those expecting rapid tax reform and sharp fiscal stimulus to accelerate growth and raise inflation and interest rates will want to avoid the sector. Portfolio managers concerned about a less clean cut outcome – e.g., fiscal stimulus is watered down by House Speaker Ryan and other GOP deficit hawks, uncertainty as to fiscal and trade policy leads firms to defer investment and hiring, overly aggressive trade policy triggers retaliation from China and other trading partners – may find regulated utilities attractive, combining higher expected medium term returns than the S&P 500, a historically low correlation with the broader market, and minimum sensitivity to economic, trade or other international disruptions. For investors expecting a messier future with fatter tail risks, regulated utilities offer the potential to mitigate portfolio volatility with little potential detriment to portfolio returns.
Portfolio Manager’s Summary
- Despite the marked increase in bond yields since the election, regulated utilities appear fairly valued following their recent pull back.
- Historically, the best predictor of regulated utility PEs has been the yield on Baa corporate bonds: a regression analysis of the two variables over the past 35 years produces an r-squared of 89%. Given Baa bond yields today, this regression equation predicts that regulated utilities should trade at a forward PE multiple of 17.1. In fact, the forward PE of the sector is 16.7 currently, suggesting that the sector is undervalued by 2.3% relative to its historical relation to Baa corporate bonds.
- Even if bond yields rise further, as expected by Wall Street economists, regulated utilities’ robust expected earnings growth in 2018 imply that the sector will likely still be fairly valued in twelve months’ time.
- The mean forecast of the 50 Wall Street economists polled by The Wall Street Journal is for the yield on the 10-year U.S. Treasury bond to rise by some 45 basis points through year-end 2017. Were Baa corporate bond yields to rise in tandem with 10-year Treasury yields, regulated utilities would be expected to trade at 16.0x 2018 earnings at year-end 2017; currently, the regulated utilities trade at 15.9x consensus 2018 earnings.
- This would suggest that the worst of the adjustment to higher rates is behind us, and it may be timely to consider how regulated utility stocks purchased today might fare relative to the market over a medium term horizon of three to five years. Given robust growth in utilities’ aggregate rate base (the capital invested in the supply of electricity, on which regulated utilities are allowed to earn a fair return), we expect earnings growth in the regulated utility sector to outpace that of the S&P 500.
- Over the last 15 years, during which nominal GDP expanded at a compound annual rate of 3.8%, U.S. regulated utilities have realized 6.5% annual growth in aggregate electric rate base (See our note of Sept. 13, Is This the Golden Age of Electric Utilities? A Primer on Historical and Forecast Rate Base Growth.) Based on utilities’ disclosed capital expenditure plans, we calculate that growth in aggregate electric rate base will continue at ~6.2% p.a. through 2020. Assuming the allowed returns on electric rate base remain constant, this should drive commensurate growth in utilities’ regulated earnings. Adjusting for the impact of equity dilution, which has run at ~1.2% p.a. in recent years, and adding the sector’s dividend yield of 3.8%, and we see the potential for total shareholder returns to utility investors of ~8.8%.
- We expect returns on the broader equity market well below this level. Consensus expectations are for ~2.2% annual growth in real GDP over the next five quarters, consistent with nominal GDP growth of ~4.3% p.a. If the S&P 500’s current dividend yield of 2.1% were to rise in line with corporate earnings, and corporate earnings to expand with the growth in nominal GDP, we calculate that the stock market is poised to offer a nominal total return of ~6.4%. (We note that the after-tax earnings of U.S. companies now account for 6.3% of U.S. GDP, over one standard deviation above the post-World War II mean of 5.2%. To assume that the growth in corporate earnings will exceed the growth of nominal GDP going forward implies a further increase in the profit share of GDP. Equally if not more likely, given the low rate of unemployment and rising pressure on wages, is the possibility that the profit share of GDP reverts to mean, continuing its recent downward trend from its 2012 peak of 7.0%.)
- Utilities’ apparent advantage versus the broader equity market in medium term earnings growth will be of little value to investors, however, if bond yields continue to rise beyond 2017. The non-partisan Committee for a Responsible Budget, in its Fiscal Guide to the 2016 Election, estimates that over ten years Trump’s proposed tax cuts and infrastructure and entitlement spending plans would raise the federal debt from $14 trillion in 2016 to $19 trillion by 2026, increasing the ratio of federal debt to GDP from 77% to 105%. Government borrowing on this scale could continue to put material upward pressure on Treasury bond yields.
- The historical relationship between utility PE multiples and the yield on Baa corporate bonds suggests that a 100 basis point increase in bond yields drives a 93 basis point increase in utilities’ earnings yield; this would require a drop of some 13% in utility share prices.
- The sensitivity of utility valuations to long term bond yields has historically caused utilities to underperform during periods of rising interest rates. Over the last 45 years, during 12-month periods in which 10-year Treasury yields have increased by 100 basis point or less, regulated utilities have underperformed the S&P 500 by an average of 190 basis points.
- Another area where utilities could be disadvantaged versus the broader equity market is tax reform, although the impacts are complicated and depend on final changes to the tax code and regulators’ response to them.
- Whereas most firms would see a permanent benefit from a reduction in the corporate tax rate, utilities may be required by regulators to return this benefit to ratepayers. Lower tax rates, however, imply a slower build-up in deferred taxes from bonus depreciation; as deferred taxes are an offset to rate base growth, tax reform may accelerate the growth of regulated rate base. Most likely to enjoy benefits in the medium term will be utilities with substantial competitive operations, FERC regulated assets or multi-year rate freezes (e.g. PEG and D); others (EIX), could see the benefits flow through immediately to ratepayers.
- Under what circumstances, then, would investors be rewarded for holding utility stocks? We can think of at least four such scenarios:
- Interest rate increases are restrained as House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell and other fiscal conservatives in the GOP caucus demand budget offsets to Trump’s proposed tax cuts to avoid a ballooning federal deficit. Alternatively, Democrats stymie the proposed tax cuts in the Senate through effective use of the filibuster.
- Economic growth slows as corporations defer investment and hiring decisions until Trump’s proposed tax, trade and immigration policies, and their implications for their operations, become clear. Higher interest rates and the dollar’s strength create additional headwinds.
- Aggressive action by the Trump administration to rectify unfair trading practices, real or perceived, by China, our NAFTA partners, and the European Union, triggers retaliatory measures that materially limit trade and disrupt the global supply chains of U.S. businesses.
- Trump’s stated intention of confronting China on its trade practices and currency manipulation; his desire to withdraw from the Iran nuclear deal and resort to economic sanctions and potentially military force to end Iran’s nuclear development program; his possible misreading of Russia’s intentions; and his threat to dissolve historical security treaty alliances with western Europe and Japan, heighten international tensions, weaken U.S. security arrangements, and increase the risk of an international confrontation.
- International trade and political crises tend to have a lesser impact on regulated utility stocks than they do on the more competitive, internationally integrated sectors of the economy. Reflecting utilities’ lack of international exposure, as well as the regulated status of their business and the critical nature of their assets, periods of rising systemic risk have tended to be periods of regulated utility outperformance.
- Similarly, the limited sensitivity of utility revenues and earnings to changes in GDP growth imply that the sector may outperform if, in the months following the election, policy uncertainty contributes to a slowdown in investment, hiring and GDP growth.
- In this context, it is important that regulated utilities’ beta, which measures the covariance of the sector’s total return against that of the S&P 500, is now at historically low levels. As can be seen in Exhibit 1, the beta of the Philadelphia Utility Index (UTY), which comprises primarily regulated utility stocks, has been 0.7 over the last 10 years, 0.6 over the last five years, 0.5 over the last three and 0.4 over the last 12 months. In the first nine months of 2016, regulated utilities’ beta has been only 0.34. Given the Trump administration’s plan to cut taxes with no offsetting brake on entitlement spending, to introduce radically new trade and immigration policies, and to revamp international relations, the risk of economic and geopolitical volatility has materially increased, rendering the historically low beta of the regulated utility sector even more attractive. In summary, at a time of increased risk, regulated utility stocks — with higher expected medium term returns than the S&P 500, and a historically low correlation with the broader market – offer the potential to mitigate portfolio volatility with little potential detriment to portfolio returns.
Exhibit 1: Beta of the Philadelphia Utility Index Relative to the S&P 500
Source: Dow Jones, Bloomberg and SSR analysis
Exhibit 2: Heat Map: Preferences Among Utilities, IPP and Clean Technology
Source: FERC Form 1, company reports, SNL, SSR analysi
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