How safe are utility stocks in a market downturn?

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 nonutility stocks.

Utility companies are perceived to be financially reliable because of their monopolistic characteristics. Owing to the necessity of the products and services that they provide, utilities thrive even in tough economic situations.

Being unaffected by business cycles is what makes utility stocks defensive because they offer greater stability compared to other companies that are more economically sensitive.

Moreover, since there is little opportunity to grow aggressively, being in a highly regulated environment, utilities return excess cash from earnings to shareholders in form of dividends.

In the midst of market uncertainties, investors who are looking for solid income stream have historically turned to utilities for steady returns.

Share prices of utility stocks often trade at a discount to market average price-to-earnings (P/E) ratio due to limited growth potentials but are less volatile compared to the overall stock market.

How defensive are the utility stocks? Market history tells us that utility stocks tend to relatively outperform the PSE index during a down market but tend to lag behind the index when the market is strong.

Based on the four major market corrections since 2007, utility stocks have outperformed the PSE index 75 percent of the time. In July 2016, when the PSE index lost 18 percent in five months, utilities lost by median of 15 percent. In April 2015, utility stocks lost only 11 percent while the PSE index lost 24 percent in eight months.

The bear market that started in October 2007 saw the PSE index losing by 52 percent in two years while the utilities lost by 22 percent. This year, the PSE index has already lost 19.7 percent since it peaked in late January while the utilities lost only 8.5 percent.

But a closer look at how the individual utility stocks in the group performed reveals that not all stocks did positively well. Historical data show that only Aboitiz Power (AP) and SPC Power Corp (SPC) consistently outperformed the PSE index in all four market corrections.

This year, both stocks have beaten the PSE index so far with AP losing 15.7 percent and SPC losing 4.6 percent against the market loss of 19.7 percent.

The next set of utilities that have historically outperformed the index in three of four major corrections are Meralco (MER), Manila Water (MWC), Petron (PCOR) and Phoenix Petroleum (PNX).

Following the law of averages, these stocks have so far fared better than the market this year with MER gaining 5.1 percent to a five-year record high, MWC losing only by 3.6 percent, PCOR, 2.0 percent and PNX, 11.7 percent.

Utilities may do well in a falling market but when the market starts to recover, they historically underperform. In December 2016 when the PSE index recovered with a 38-percent gain, utilities only managed to grow by 5.4 percent.

In January 2016, the PSE index rallied for seven months with 29 percent gain but utilities only increased by 17 percent. The same situation also happened in December 2013 when the PSE index staged a 16-month uptrend to gain 40 percent, but utilities lagged behind with a 30-percent recovery.

While utilities in general are more stable than the PSE index when the market is weak, bear in mind that they do well only on relative basis.

Utilities may be a safe haven but they do not come without risks.

Risks of rising interest rates brought about by growing inflationary pressure may significantly affect the utilities sector. Utilities can lose so much during a market crisis though the extent of losses may be lower.

Every stock is different because not all share the same risk, growth and cash flow profile. Always choose the utility stocks that offer the lowest risk in a volatile stock market.