Thus far, 2022 has been a series of jagged ups and downs for global stock markets, with most prices ratcheting lower. Bonds have fared even worse, with the benchmark 10-year Treasury yield rising nearly a percentage point.
Regulated US utilities, however, have been staging a quiet rally. Earlier this month, the Dow Jones Utility Average briefly crossed the 1,000 mark for the first time in its nearly 100-year history. This week, the 15-stock average broke through again, lifting its year-to-date return nearly 10 percentage points ahead of the S&P 500,
Utilities’ surge caught the popular investment media flatfooted. That’s largely because of the fallacious narrative these stocks are “interest rate sensitive,” despite the utter lack of correlation between utility returns and changes in benchmark rates. Since 1993, for example, the DJUA has finished a calendar year underwater just six times, half of them with rates falling.
Neither has monetary tightening by the US Federal Reserve historically depressed utilities’ returns. From June 2004 through June 2006, for example, the central bank lifted the Fed Funds rate from 1 percent to 5.25 percent. The DJUA’s response: A nearly 60 percent return, one of its best two-year runs in its history.
Like every capital-intensive business, utilities are major borrowers. And prices of longer-term sector bonds have dropped this year. Dominion Energy’s 5.75 percent bonds of October 1, 2054for example, have slipped from 110 to 101, pushing their yield to maturity to around 5.5 percent.
So far, the backup in yields hasn’t impacted utilities’ bottom lines. Companies like Dominion Energy (D) took full advantage of years of very low interest rates, extending maturities to limit near-term refinancing needs while cutting costs.
New issues have been scarce in recent weeks. But what financing there’s been has further cut costs, in part because utilities can now access the low-cost “sustainable” bond market. That includes $900 million of new debt issued earlier this month by Duke Energy (DUK), featuring 30-year bonds paying just 4 percent.
The longer inflation persists, the more utilities will depend on their regulators to adjust rates to keep up with higher borrowing costs. But I think most states will attempt to do this in a balanced way, given how important utilities’ ability to access low cost capital is to ambitious energy transition goals.
For now, such concerns have been pushed aside by several key catalysts fueling this rally:
- “Reshoring” of investment in the US stock marketas European markets stagger and the Euro/US dollar exchange rate slips under $1.10.
- Regulated US utilities’ almost exclusively domestic focus, including for energy purchases. Investors can be confident there won’t be any big hits to the bottom line from sanctions on Russia and its ally Belarus.
- Regulated utilities proved their business resilience in 2020 when the pandemic triggered a drastic contraction in multiple sectors of the US economy. And there’s every reason to expect them to hold up again, if the Federal Reserve fails to thread the needle between reducing inflation and keeping the economy running.
- The DJUA’s current yield is 2.3 times what the typical S&P 500 ETF pays. And best in class companies have a clear path to increase dividends at least 6 to 8 percent annually, good enough to match even the current inflation rate.
Two more potential upside catalysts for the sector in coming months are stepped up M&A activity and possible new federal tax cuts,
Build Back Better may not see the light of day. But souring oil and gas costs appear to be pushing the Biden Administration toward more of an “all of the above” energy policy.
This week, for example, the president announced the US will more than double LNG exports to Europe by 2030. That implies the federal government will approve dramatic expansion of export infrastructure. And the Federal Energy Regulatory Commission has more or less confirmed that, by shelving a rule to require a climate impact review for all new natural gas infrastructure.
No guarantees. But I expect the Administration’s newfound pragmatism will encourage key members of Congress like Senator Joe Manchin (D-WVA) to unblock tax cut extensions and subsidies for a range of energy transition initiatives that will benefit utilities. And as NextEra Energy’s (NEE) outgoing CEO Jim Robo put it during the renewable energy leader’s Q4 guidance call, that would be “an accelerator” to already robust projected business growth.
Turning to mergers and acquisitions, privately held Infrastructure Investments Fund’s $36 per share all-cash takeover offer for South Jersey Industries (SJI) in late February clearly indicates big investors see natural gas distribution assets as starkly undervalued. That’s certainly the view of activist investor Carl Icahn, who this month increased his tender offer for Southwest Gas Holdings (SWX) by 10 percent to $82.50 a share.
To date, there’s never been a successful hostile takeover of a regulated US utility. And Icahn faces long odds winning approval of regulators in Arizona, California and Nevada, as well as the Democrats’ current 3-2 majority on FERC. Rather, the game is control of Southwest’s board of directors, to force actions. Icahn says could make the stock worth $110 to $150 a share.
I think Southwest shareholders should bet with him, which ironically is best done by not tendering your shares. Even if Icahn loses, the company’s management plans to spin out the Centuri construction unit “within the next 9 to 12 months,” which will unlock additional value.
Icahn’s bid has also bolstered prices of other gas distribution utilities, notably best of the biggest Atmos Energy (ATO). And it’s elevated companies like Centerpoint Energy (CNP), which have gas units they may want to sell.
So how much higher will these factors push utilities’ quiet rally? A lot depends on the economy avoiding recession and stocks a bear market.
I prescribe a three-part strategy, which goes for other dividend paying stocks as well. First, sell any company showing business weakness. If there is a bear market, the strong will rebound when the dust clears. The weak offer no such assurance.
Second, take partial profits if buying momentum pushes stock prices to extremes. My updated “Portfolio Holdings Trading Above Target” list appears in every issue of Conrad’s Utility Investor—and is a comprehensive guide for this element of my strategy.
And finally, build a list of high quality stocks to buy if their prices drop enough. That’s the point of my “Dream Buy” strategy, which is also featured in every monthly issue of CUI,
Stock investing in 2022 means managing war, pestilence, 40-year high inflation, rising interest rates and still historically high measures of standard valuation for market leaders. But on the other hand, after lagging the post-pandemic rally, utility stocks have the wind at their backs for now.
That makes this the time for incremental moves, not radical ones. And that’s how I intend to ride the remainder of utilities’ quiet rally.
Credit: www.forbes.com /