Frankly, finding fair value in today's market is, in fact, becoming a rarity.
Consequently, it might make sense for the most cautious investors out there to consider defensive equity investments as a compromise option.
Three examples of established utility stocks with investment-grade credit ratings and historical records of producing stable earnings and dividends.
The primary objective of this article is to present viable income options to those investors that are concerned about a potential market correction and/or the current state of our economy.
Retired investors, or those nearing retirement, that are looking for and in need of safe and attractive income investments are faced with unusual challenges in today's financial markets. After a long bull run, common stocks are starting to look more and more extended based on valuation. Consequently, it is getting more and more difficult to find high-quality, blue-chip, dividend-paying stocks that can be purchased at fair value.
Although I have been on record many times stating that it is a market of stocks and not a stock market, I do agree and respect the wisdom of legendary investor Warren Buffett when he said: "The market is there only as a reference point to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses."
Therefore, I offer the following earnings and price correlated graph of the S&P 500 index (^SPX) as a reference point, as Warren Buffett suggested. The S&P 500 currently trades at a blended P/E ratio of 17.5. Although this is lower than the calculated normal P/E ratio of 19.3 (the dark blue reference line on the graph), it should be recognized that this calculation is skewed, due to the high P/E ratios that the market traded at during the irrational exuberant time period that culminated in calendar year 2000.
Otherwise, I consider the more normal 200-year average P/E ratio of approximately 15 (the orange reference line on the graph) as the more reliable indicator of fair value for the market. On that basis, the stock market in the general sense is clearly overvalued, but not to the dangerous extent that many people seem to believe. In my opinion, since this is an index comprised of 500 different stocks, I see it as merely suggesting that finding fair value in this market has clearly become more difficult.
To corroborate that view, I have examined numerous blue-chip dividend paying stocks on an individual case-by-case basis, which I consider to be a more fact-based approach. Frankly, I must ruefully admit that finding fair value in today's market is, in fact, becoming a rarity. This is not to say that there are not any high-quality, blue-chip, dividend paying stocks that can be purchased at fair value, because I have found many. However, I am saying that the "pickins" are getting slim. This is clearly a challenge to the retired investor desirous of income and safety.
I have also been on record many times stating that I believe there are only two broad asset classes - equity and debt. Therefore, turning to the fixed income (debt) asset class, we also discover unusual and challenging circumstances. Interest rates have consistently fallen for almost three decades, which has currently brought them to unacceptably low levels of yield.
The challenges that this brings to the retired investor desirous of income are many. Bonds and other fixed income instruments have long been coveted for their typical characteristics of safety and yield. Unfortunately, with yields hovering at all-time lows, bonds and other fixed income instruments do not offer enough income to meet daily living needs, and are certainly not high enough to overcome potential inflation risk.
Additionally, the typical safe nature of a bond has also disappeared because as interest rates rise, bond prices will surely fall. Since only the longest maturing bonds offer anything that could even be considered yield, the price volatility risk of investing in them has become aberrantly high. The following graph plotting the yields of the 10-year treasury since the 1960s clearly reveals my thesis. This leads to the question - what should the prudent investor do in order to find both safety and adequate yield?
In Today's Economic Environment, Perhaps the Best Offense Is a Good Defense
Personally, I favor a strategy of building dividend income portfolios one company at a time, based on the merits and valuation of each selection under consideration. However, I can understand how some investors might be more cautious given the circumstances described above. Consequently, it might make sense for the most cautious investors out there to consider defensive equity investments as a compromise option. I would rather investors do that over doing nothing, to paraphrase an old adage - Money at rest gathers no returns.
In order for me to consider a company as a defensive stock, it must offer stable earnings and a constant dividend, regardless of the state of the overall stock market or economy. But perhaps more importantly, it should also offer a history of stable prices. Many professional investors and lay investors alike have long considered the utility sector as defensive. However, I would add that not all utility stocks are defensive, but many clearly are.
3 Defensive, Fairly Valued Utility Stocks Offering High Yield:
With this article, I present three examples of established utility stocks with investment-grade credit ratings and historical records of producing stable earnings and dividends. Moreover, although my primary focus is on each company's stable and long record of paying dividends; my secondary focus is on the stability of their historical stock price movement. These are the two factors that I require a company to possess for me to call it a defensive holding. I offer the three utility stocks presented here as examples of companies that possess those two critical factors.
However, there is an important caveat that I believe that prospective investors must carefully consider and closely monitor. Since utility stocks require significant infrastructure, they are required to carry large debt loads. My debt threshold when evaluating utilities is a debt-to-capital ratio of 60% or less. All three of the examples I will present here have debt-to-equity ratios of 50% or less, and well below my threshold.
The reason why utilities often carry large amounts of debt is because they require significant infrastructure in order to provide their services to customers. Consequently, investors should be alerted to the effect that interest rates might have on their businesses. However, due to the regulated nature of their businesses, the current debt expense will be factored in when presenting to regulatory boards. Nevertheless, the company's debt loads relative to current interest rates should be continuously monitored when investing in utility stocks. One metric that is often utilized and accepted when evaluating public utilities is that their debt should not exceed twice their equity or book value. When I present these three examples, I will illustrate that all three of these utility stocks meet that requirement.
In order to present the defensive nature of these three public utility stocks, I will present them in the following format:
First, I will share a long business description of each company courtesy of Standard & Poor's Capital IQ. I will follow that with a few slides from each company's recent presentations to analysts or investors that address important considerations, such as each company's regulatory environment, its energy generation mix, and finally, its long-term dividend records.
Then, I will turn to F.A.S.T. Graphs™, the fundamentals analyzer software tool that will allow the reader to evaluate each company's historical earnings and price correlation and dividend record. These graphs are presented so that the reader can review the stability of each company's stock price since 2004, which is a time frame that includes the Great Recession.
The earnings and price correlated graphs will be followed with several F.U.N. Graphs (fundamental underlying numbers) that will present important balance sheet considerations, income or cash flow considerations, and finally, a graph depicting each company's historical price-to-book value and beta. Although personally I am not a fan of beta, I will submit that this metric does provide evidence of the defensive nature of each of these companies' stock price.
For the most part, and for the sake of brevity, I will provide annotations to each graph, thereby letting the graphs speak for themselves, and provide only brief commentary where I consider it necessary for clarification. Therefore, the true value of what follows will come from a careful analysis of the slides and graphs that are presented.
"SCANA Corporation, through its subsidiaries, is engaged in the generation, transmission, distribution, and sale of electricity to retail and wholesale customers in South Carolina. It owns nuclear, coal, hydro, natural gas and oil, and biomass generating facilities. The company also purchases, sells, and transports natural gas; offers energy-related risk management services; and provides service contracts on home appliances, and heating and air conditioning units. In addition, it owns two liquefied natural gas plants in Charleston and Salley, South Carolina; and offers tower site construction, management, and rental services, as well as sells towers in South Carolina and North Carolina.
As of December 31, 2013, the company supplied electricity to approximately 678,000 customers; and provided natural gas to approximately 509,000 residential, commercial, and industrial customers in North Carolina and South Carolina, as well as markets natural gas to approximately 454,000 customers in Georgia. Further, SCANA Corporation owns and operates a 1,125 mile fiber optic telecommunications network and Ethernet network, as well as data center facilities in South Carolina.
Additionally, it builds, manages, and leases communications towers with interests in 2,280 miles of fiber in South Carolina, North Carolina, and Georgia through a joint venture. The company's customers comprise municipalities, electric cooperatives, other investor-owned utilities, registered marketers, and federal and state electric agencies. It also serves chemical, educational service, paper product, food product, lumber and wood product, health service, textile manufacturing, rubber and miscellaneous plastic product, and fabricated metal product industries. The company was founded in 1924 and is based in Cayce, South Carolina."
SCANA: Regulatory Environment
SCANA operates in a reasonably friendly regulatory environment, as depicted by the following slide:
SCANA: Energy Generation Mix
SCANA: Long-term Dividend Record
SCANA: Earnings and Price Correlated Graph
SCANA: Balance Sheet Considerations
SCANA: Cash Flow Statement
SCANA: Price-to-Book Ratio
Consolidated Edison, Inc.:
"Consolidated Edison, Inc. is engaged in regulated electric, gas, and steam delivery businesses in the United States. The company, through its subsidiary, Consolidated Edison Company of New York, Inc., provides electric services to approximately 3.4 million customers in New York City and Westchester County; gas to approximately 1.1 million customers in Manhattan, the Bronx, and parts of Queens and Westchester County; and steam to approximately 1,703 customers in parts of Manhattan. It operates 62 area distribution substations and various distribution facilities; 39 transmission substations and 62 area stations; electric generation facilities with an aggregate capacity of 702 megawatts that run with gas and fuel oil; 4,307 miles of mains and 367,555 service lines for natural gas distribution; and 1 steam-electric generating station and 5 steam-only generating stations.
The company, through its subsidiary, Orange and Rockland Utilities, Inc., also supplies electricity to approximately 0.3 million customers in southeastern New York, and in adjacent areas of northern New Jersey and northeastern Pennsylvania; and gas to approximately 0.1 million customers in southeastern New York and adjacent areas of northeastern Pennsylvania. It operates 557 circuit miles of transmission lines; 14 transmission substations; 61 distribution substations; 85,986 in-service line transformers; 3,828 pole miles of overhead distribution lines; and 1,827 miles of underground distribution lines, as well as 1,862 miles of mains and 104,713 service lines for natural gas distribution. In addition, the company is involved in the sale and related hedging of electricity to retail customers; and sale of energy-related products and services to wholesale and retail customers, as well as participates in energy infrastructure projects. It sells electricity to industrial, commercial, residential, and governmental customers. The company was founded in 1884 and is based in New York, New York."
Consolidated Edison: Regulatory Environment
Consolidated Edison: Energy Generation Mix
Consolidated Edison: Long-term Dividend Record
Consolidated Edison: Stability Through Many Economic Challenges
Consolidated Edison: Balance Sheet Considerations
Consolidated Edison: Cash Flow Statement
Consolidated Edison: Price-To-Book Ratio
The Southern Company:
"The Southern Company, together with its subsidiaries, operates as a public electric utility company. The company is involved in the generation, transmission, and distribution of electricity through coal, nuclear, oil and gas, and hydro resources in the states of Alabama, Georgia, Florida, and Mississippi. It constructs, acquires, owns, and manages generation assets, including renewable energy projects. As of December 31, 2013, the company owned and/or operated 33 hydroelectric generating stations, 32 fossil fuel generating stations, 3 nuclear generating stations, 13 combined cycle/cogeneration stations, 6 solar facilities, 1 landfill gas facility, and 1 biomass facility.
The company also provides digital wireless communications services with various communication options, including push to talk, cellular service, text messaging, wireless Internet access, and wireless data; and wholesale fiber optic solutions to telecommunication providers in the Southeast under the Southern Telecom name. The company was founded in 1945 and is headquartered in Atlanta, Georgia."
Southern Company: Regulatory Environment
Southern Company: Energy Generation Mix
Southern Company: Long-term Dividend Record
Southern Company: Balance Sheet Considerations
Southern Company: Cash Flow Statement
Southern Company: Price-To-Book Ratio
Summary and Conclusions
The primary objective of this article was to present viable income options to those investors that are concerned about a potential market correction and/or the current state of our economy. Stated more clearly, I consider the examples presented in this article as reasonably safe and attractive places that investors needing income could turn to in today's low interest rate environment and fully valued stock market.
With the above in mind, I will add that the reader should be cognizant of the fact that high-yielding utility stocks offer little in the way of long-term capital appreciation, due to their regulated growth. However, they do offer the potential for capital appreciation in the range of 3% to 5% per annum, if they are purchased at fair value. I believe that each of the three examples presented here qualify.
Regarding income, all three of these candidates provide current yields of 4% or better, coupled with dividend growth that I believe will correlate to each company's future earnings growth. But once again, the dividend growth rate will most likely be less than available from faster-growing stocks in other sectors.
Consequently, I am suggesting that these candidates each represent a reasonably high-yielding and safe option in today's difficult market environment. In that same respect, they can be utilized as temporary vehicles in which to park cash reserves, or be utilized as long-term high-yielding vehicles as well. In either case, I consider this option superior to sitting on cash producing little opportunity for yield or capital appreciation. Due to the stable nature of their stock prices, their consistent earnings and dividend records, I believe the odds of earning less than cash to be small.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: The author is long SCG, SO, ED. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.