Feeling risk averse? Dependable utility stocks are gaining favour

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Regulated utilities have been outperforming the broader stock market over the past six weeks, suggesting that attractive dividends and a defensive business model are alluring features amid economic uncertainty – especially on days when the market turns rocky.

Among key Canadian names, Fortis Inc.’s share price has risen 7 per cent since the end of June, or more than five percentage points better than the S&P/TSX Composite Index. Hydro One Ltd. and Emera Inc. are both up about 5 per cent over the same period.

All three stocks held up relatively well on Tuesday, when the TSX fell 0.6 per cent during the worst day for stocks in about a month. Fortis dipped just a penny while Emera gained 0.3 per cent.

U.S. utilities have been on a similar winning streak, emerging as the top-performing sector in the S&P 500 in the third quarter, with gains of more than 8 per cent after a disappointing first half of the year.

“We’ve long attributed the first half weakness to investors chasing beta” – or riskier stocks that can generate strong returns – “as they’re drawn to historical growth outlooks for most sectors, driven by macroeconomic recovery, and thus leaving utility stocks behind,” Andrew Weisel, an analyst at Bank of Nova Scotia, said in a note this week.

So what has changed?

For one, the spectacular rebound in risk appetite this year, driven by vaccine rollouts and reopening businesses, has given way to sober second thoughts.

Many economists expect that economic growth has already peaked. Central banks are now discussing timetables for withdrawing extraordinary stimulus, laying the groundwork for eventual interest rate hikes.

Bond yields, which move in the opposite direction to bond prices, have been subsiding for much of the past four months, after yields shot higher in the first quarter of 2021.

The yield on the 10-year U.S. Treasury bond briefly fell below 1.25 per cent on Tuesday, down from a recent high above 1.7 per cent in March, suggesting that investors now see little threat from inflation.

Investors also may be wary of cracks in the economic recovery.

Tuesday’s market turbulence, which hit economically sensitive sectors such as car manufacturers, airlines and consumer stocks particularly hard, followed a report showing that U.S. retail sales fell 1.1 per cent in July, compared with June.

“Although American shoppers have plenty of pent-up demand, supply shortages are curbing production and lifting prices, while the Delta variant remains a headwind,” Priscilla Thiagamoorthy, an economist at BMO Capital Markets, said in a note.

Little wonder, then, that utilities – which keep the lights on in good times and bad, and can be counted on to raise their dividends regularly – look like attractive bets in this sort of environment.

The renewed interest among investors, though, is driving valuations higher, given that share prices are rising faster than profits. Based on Scotiabank’s estimates for 2021 earnings for Fortis, Hydro One and Emera, the group now trades at an average forward price-to-earnings ratio of 20.9, up from 20.1 in June.

Some observers are a bit squeamish. After Fortis reported its second-quarter financial results last month, David Quezada, an analyst at Raymond James, maintained a lacklustre neutral recommendation on the stock because of its premium valuation.

UBS also has a neutral recommendation on Fortis, while Scotiabank has a similar view (they call it “sector perform”) on Hydro One.

But it’s hard to argue against the stability of these stocks when investor sentiment sours on riskier bets. And with dividend yields ranging from 3.4 per cent (in the case of Fortis and Hydro One) to 4.3 per cent (Emera), regular quarterly distributions can look very attractive when the broader market wobbles.

Full disclosure: The author owns shares of Hydro One.

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