One of the sectors most often associated with income investing is utilities. In keeping with the theme of defensive investing strategies I've been discussing for several years, and most recently yesterday, the sector is also an excellent place to allocate long-term investment capital when the rest of the market appears to be premium priced.
I believe the majority of the S&P 500 is currently priced at a premium to economic fundamentals because most of it is concentrated in areas that require strong end-consumer demand.
Before going further, I must add that the utilities I'm about to discuss are also priced at a substantial premium to their historical valuations. As such, even though ALM Advisors currently has positions in three of the stocks mentioned, we are vigilant for a positive turn in economic activity, which could be detrimental to the share prices.
However, we do not believe a positive turn in economic activity that would drive up long-end Treasury yields and cause these stocks to sell off is probable in the near future. We think it is more likely that economic activity will continue to underperform.
The strategy I will outline, though, is one we keep in mind as we monitor these stocks and the utilities sector overall. It is part of an actively managed portfolio strategy -- not a passive long-term buy-and-hold one.
Growth in consumer demand and aggregate real economic activity is being hindered by a lack of job creation coupled with existing high levels of consumer debt. As a result, allocating investment capital to sectors that are less sensitive to consumer demand is prudent. One of those sectors is utilities.
One of the easiest ways to think about this investing strategy is to separate personal income into its two primary parts: disposable and discretionary. Disposable income is essentially after-tax income used to pay for "needs." Discretionary income is what's left over after both taxes and needs are paid for, and may be used to pay for "wants."
Needs include mortgage, rent, real estate taxes, water/sewer, insurance, groceries, telephone/internet, debt payments, transportation and, of course, utilities -- most often natural gas and electricity.
The best utilities to use in a defensive approach are part of the "40-Plus Club," outlined by Glenn Williams in previous Real Money columns. These companies are large, diversified and regulated utilities with enterprise values in excess of $40 billion. They are also among the highest dividend-yielding utility stocks.
For the purposes of this column, I am limiting the discussion to the four largest "club" members: Southern Company (SO) with a dividend yield of 4.40%; Dominion Resources (D), yielding 3.40%; NextEra Energy (NEE) with a yield of 2.90%; and Duke Energy (DUK) yielding 4.00%.
Of these, ALM Advisors currently has positions in Southern, Dominion, and NextEra.
The first issue to address is the sensitivity of these stocks to increases in long-end Treasury yields, with last year's rate spike providing a timely record. In the latter half of last year, the 10-year Treasury yield rose to 3.04% from about 1.66%. During the same time period, shares of Southern, and Duke declined about 16% and 8%, respectively, while those of Dominion and NextEra rose about 4%.
Given that last year's rate spike was the fastest in U.S. history, the performance of these stocks was quite good. However, since the end of the last recession each of these issues has risen to levels that put them at about a 40% premium to their historical averages, as measured by their price-to-earnings ratio. Southern is up about 50%, Duke has increased 85%, Dominion has risen 110% and NextEra is up 75%.
What's important about this is that the profit margins allowed for regulated entities are tied to their equity. That means they are now, by definition, premium-priced and must either grow their equity to meet the premium or at some point the premium must go away in order for the stock price to meet the allowed cash flows.
I will deal with that issue in a separate column.
The point now is that these are safe issues in which to park assets, especially if the economy continues to underperform expectations. Even if economic activity shows signs of rebounding and/or long-end Treasury yields spike again, these stocks should not suffer a swift selloff.