Utilities – Reward-free risk?
Paraphrasing Charlie Munger, as investors, all we want to know is where we are going to die, so we won’t go there. Common sense dictates that investors should avoid overcrowded trades in companies with lots of fundamental business risk, overleveraged balance sheets and which are priced at historically high valuations. According to one of the most diverse and wide-ranging surveys of global fund managers (Global FMS survey), the most crowded trades today are quality stocks, utilities and stocks with bond-like qualities that will benefit from further easing by central banks and are likely to have the least downside in the event of a recession. In other words, fund managers continue to believe that what worked best in the recent past will continue to work best in the future. In 2015, “momentum investing” was the top returning investment strategy for the year.
We believe momentum investing makes sense when a stock’s performance is paired up with its business momentum – think Starbucks, Microsoft, and Google in their heyday. The performance of such stocks is simply following the momentum of their underlying businesses. We categorize such stocks as Compounders. On the other hand, we are skeptical when momentum investing is driven primarily by expansion of valuation multiples rather than expanding earnings power, particularly after a long run up when valuation metrics have become very stretched by historic standards (think the late 1990s dotcom bubble). Performance looks the same to investors focused on price action, making stocks in this second category much more vulnerable. In our view, large parts of the market are experiencing momentum investing of the second category. Perhaps a poster child of yield-driven momentum investing in early 2016 is the S&P500 Utilities sector.
For the first half 2016, the S&P500 Utilities sector has been on fire, delivering total returns of 23%, only slightly lower than the return for S&P500 Telecom sector of 25%. Both sectors have historically been considered “safe” due to their predictable business profiles and bond-like qualities. Dividends account for a high percentage of investors’ total return rather than capital appreciation and their yield has attracted investors like bears to honey. From our viewpoint, downside risks are growing by the day (see How Pender thinks about risk).
Today the utilities sector is red lining on almost every simple valuation metric (P/E, EV/EBITDA, EV/Sales). At best, one can say is that utilities look reasonable relative to ultralow interest rates. In our view, utilities are priced to perfection with very high absolute valuation risk, only justifiable if nothing goes wrong within their business model in the future. In the best of times, utilities are capital intensive, predictable businesses with only modest ability to grow their earnings power. Valuations should be similarly modest relative to other sectors with more robust prospects.
Balance Sheet Risk
Balance sheet risk is also a concern in our view as utilities have taken on higher debt levels to acquire regulated assets at premium prices. Financial leverage is not necessarily an issue when it is used prudently to buy low risk assets with highly dependable cash flows. Unfortunately, the rush to buy regulated assets comes just on the eve of potentially vast industry change where old economic realities could be displaced with new ones. Simply put, it doesn’t matter how low interest rates stay if the fundamental legacy utilities business model and the cash flows it generates are in jeopardy. Even if industry change is not impending, empirical research shows that most utility mergers destroy shareholder value. The track record of large sector-wide merger & acquisition booms does not inspire great confidence that this current period will fare much better. Not so long ago European utilities went through a similar M&A boom. In hindsight, it is clear the sector overspent on pricey acquisitions as they have been writing those investments down since.
Most importantly, we believe the business risk for legacy electric utilities may not be fully appreciated by those income-seeking investors who believe the past is a proxy for the future. Their rosy outlook, apparent as they bid up the sector to heady valuations, is in stark contrast to the view of many utility executives. Of note, a recent trade journal reported that half of electric utility executives it recently surveyed expect their industry to go into a “death spiral” within 10 years. Such insider sentiment is alarming because senior executives tend to be an optimistic bunch.
The Disruptive Future
What is driving this grim sentiment? Two potential disruptive technologies could upend today’s grid-based utilities and traditional power producers: better batteries and local distribution networks. Investors should look overseas to see the consequences that shifting business models and technology disruption can have on equity values. European utilities wrote off a record amount of value from their assets last year, bringing total costs to more than EUR100 billion over the last six years. Some of this was goodwill due to overspending in the previous M&A boom, but a larger portion of the write off has come from formerly productive physical assets that were no longer viable. The faster-than-expected pace of Europe’s renewables revolution stranded a lot of power producing assets and made them uneconomic. Low electricity prices and the boom in wind and solar power have devastated the stocks of the big incumbent German utilities. Analysts at investment bank Jefferies have called the value destruction over the past few years “biblical”. So much for safe and predictable.
In contrast to Germany, the US electrical grid and its legacy utilities are just at the early stages of their own transformation. While investors with shorter time horizons see little threat and are driving stocks higher in their search for yield, many industry executives with longer-term perspectives see greater peril. We side with the sector’s bearish insiders and believe utilities carry more potential risk than commonly perceived. Valuation risk alone is enough to keep us at bay. But the big potential upheaval from the transformation looming on the horizon could add further downside risks to the mix, especially for a conservative industry that is not accustomed to dealing with big change. The surge in the stocks of American utilities in early 2016 reminds of us of a cartoon we saw years ago. An executive at a podium sums up his presentation to an audience, “And so, while the end-of-the-world scenario will be rife with unimaginable horrors, we believe that the pre-period will be filled with unprecedented opportunities for profit”. For interested readers, we recommend reviewing the articles listed in the links below.