Do utility stocks perform well when inflation is high?
Investing in utility stocks has been traditionally regarded as a classic defensive strategy, especially in times of market volatility, because utilities are relatively more stable than regular stocks.
Utility companies tend to be unaffected by economic ups and downs of business cycle since they provide basic amenities that have low demand elasticity, such as water, electricity and power generation.
Because of the reliability of revenue streams that utilities enjoy, many companies in this sector can afford to pay consistent and relatively high dividends to shareholders.
The average annual dividend payout ratio of utility sector last year was 38.6 percent, which offered an average dividend yield of 4.8 percent at current prices.
Being in a mature industry with predictable earnings growth, utilities also offer low average price-to-earnings (P/E) ratios compared with other sectors in the market, making them attractively safe and less risky.
The average P/E ratio of the utility sector today is 11 times, which is 35 percent cheaper than the P/E average of the Philippine Stock Exchange (PSE) index at 16.7 times.
But how defensive are the utility stocks, especially in a rising interest rate environment?
We know that historically, high inflation and interest rates can cause stock prices to fall and utilities are no exemption. Market history shows that utility stocks tend to fall when interest rate increases 76 percent of the time for the past 22 years.
But a closer look will also show that utility stocks, in general, tend to outperform the PSE index during a down market.
For example, during the past six major market corrections since 2007, utility stocks have outperformed the PSE index more than 80 percent of the time.
When the global financial crisis broke out in October 2007, the PSE index went downhill for two years, losing 47 percent while the utility stocks lost only 9.64 percent.
In April 2015, the PSE index again declined for nine months, losing 13.3 percent but utility stocks bucked the trend and gained 10.2 percent.
When the stock market peaked in January 2018, the PSE index lost 18.5 percent in 10 months before it started to recover, while utility stocks lost only 6.7 percent.
During the height of the COVID-19 pandemic in March 2020, the PSE index took a deep dive with a huge loss of 33.8 percent from its recent high in July 2019, while utilities suffered a lower loss of 30.5 percent.
Not all boats lifted
Now, if we will look at how the individual utility stocks have performed within the group relative to the market, we will find that not all stocks have done positively well.
For example, during the 2007 global financial crisis, when the PSE index lost by 47 percent, Meralco gained by 5.4 percent while First Gen fell by 61.7 percent.
Again, during the recent pandemic crisis when the PSE index lost 33.8 percent, only SPC Power, among the utilities, went up by 17.5 percent, while Manila Water suffered the most with 59.5 percent loss.
One reason for such differences in performance can be traced to differences in risk profile of utility stocks. Riskier stocks tend to have higher cost of equity, which lowers their residual earnings.
For example, at current 10-year bond yield of 6.04 percent, Manila Water’s cost of equity is estimated at 9.84 percent. If we compare this against the stock’s return on equity (ROE) of 7.3 percent, we will find that the stock has negative spread of 2.5 percent.
Because the risk is higher than the return of the stock, Manila Water has underperformed the PSE index with a year-to-date loss of 25.7 percent against market’s loss of 5.5 percent.
This differs greatly with Meralco, which has a year-to-date gain of 19.4 percent because its ROE of 27 percent is almost three times its cost of equity of 8.5 percent.
The average residual spread of the utility sector to date at current interest rate is 5.48 percent. Picking utility stocks that offer above average residual earnings can help minimize underperformance.
Some of these utilities that can potentially outperform during this market downturn are: Synergy Grid, which has residual spread of 17.9 percent; and SPC Power, which has spread of 9.7 percent.
Utility stocks can offer safe haven in times of uncertainty, but always choose those that can offer highest return with lowest risk. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools are provided by First Metro Securities. To learn more about investment planning, attend the 95th batch of RFP program this May 2022. To register, email [email protected] or text at 0917-6248110.
