Why You Should Not Sell Utility Stocks Short Now

|
Includes: D, DUK, NEE, SO, XLU
by: PendragonY

Summary

A recent article tries to make the case that selling utilities short now is a good investment choice.

Several alarming statements are not borne out by historical facts.

Dividend growth investors would do better to go long.

In a recent article on SA, The Mad Hedge Fund Trader wrote an article, where he advised investors to dump their utility stocks. He even went so far as to recommend shorting the Utility Select Sector SPDR ETF (NYSEARCA:XLU). I disagree with his analysis, particularly with his recommendations to short utility stocks.

What did The Mad Hedge Fund Trader say about utilities?

For the most part, MHF Trader writes an article centered on the conventional wisdom that the share price of utility companies will decline with rising interest rates. And it's clear that the Fed has now embarked on a path that will eventually lead to higher interest rates. I don't agree that utilities are a bad investment in an environment of gradually increasing interest rates, especially when the economy is growing, but it is a reasonable and logical position to take. However, MHF Trader takes a much more alarmist view that I think is unwarranted.

What do I think about the issues raised?

First, let me be clear on one thing. The Fed is clearly intent on raising interest rates to combat future inflation. This will eventually cause longer-term interest rates to increase. When that happens, some investors who bought utility stocks because the yield on bonds was unacceptably low will take their money and put it back into bonds. This will certainly put downward pressure on utility share prices. That doesn't seem to be happening now, but given enough action by the Federal Reserve, it will happen at some point. If your investment goals depend on capturing capital gains, you might want to think about when is a good time to sell your utility stocks.

However, that isn't the picture painted by MHF Trader. The following phrase paints a far more alarming picture.

"If interest rates rise, utilities uniformly get killed. They also get killed by inflation, which finally seems to be entering a prolonged uptrend as well."

I don't see that as a fair representation of how utilities perform in a rising rate environment or a rising inflation environment either. So let's take a look at some graphs.

This first YChart plots the ETF XLU against the 10-year Treasury rate. During the time period of 2004 to 2008, the Treasury rate was trending up slightly, but contrary to what one might think based on MHF Trader's assertion, XLU had a good run upwards in price. During this time frame, we saw the end stages of the housing boom, where lots of new houses were built and occupied by people. It makes sense that during this time of economic expansion, utilities performed well. One might argue that the modest increase in interest rates was more than offset by the positive effect of economic growth. But that still argues against the claim that utilities uniformly get killed in a rising rate environment.

When the share prices of several utilities mentioned in the article - Dominion Resources (NYSE:D), Duke Energy (NYSE:DUK) and Southern (NYSE:SO) - are plotted against the 10-year Treasury rate, it's clear, that while very high interest rates are no friend to utility share prices, it's incorrect to claim that they are "uniformly killed" by higher rates.

Looking at just the period from January 1, 1974 to December 31, 1985, we can better see the effects of both high interest rates and climbing interest rates. Starting around 1997, interest rates began to climb. At first, this does appear to push the utilities share prices down, but after 1980, when rates continued to climb and hit their peak, the prices of utility stock had begun to grow as well. Note the couple of fairly dramatic shifts in interest rate increases that we are unlikely to see in the near future (we aren't even likely to see total interest rates close to the amount they increased in this period in fact), the share prices don't react very much.

Here is a plot of share prices against inflation. Note that while inflation spikes do cause downward pressure on share prices, I don't see any blood; much less the dead bodies MHF Trader would lead us to expect. Some investors today might not remember what the economy was like back in the late 1970s and early 1980s, but it was very bad and made the Great Recession look pretty good in comparison. I don't expect conditions like that to happen in the next 4 to 5 years, so I don't expect the impact on utility share prices to be as great either.

Next, MHF Trade paints an alarming picture of the debt held by various utilities. He uses adjectives in the place of any actual data on how much a burden the debt actually places on the company and no analysis of how interest rates will alter the costs of such debt.

"Take a look at NextEra Energy alone, which carries a backbreaking $65.65 billion in liabilities on its balance sheet, including $27.81 billion in long-term debt."

That certainly sounds like a lot of debt. But is it actually? NextEra Energy (NYSE:NEE) has some $88 billion in assets and S&P gives it a credit rating of A-. Companies with debt loads that are accurately called back-breaking just don't get rated that high. And much of its debt is fixed rate, so the effects of increasing interest rates would be felt well after rates had risen. And these companies are regulated monopolies, and as such are allowed to recoup costs, like increases in interest rates.

I wrote articles on each of these 4 utilities, and while increasing interest rates might slow their profit growth, it won't kill them or their share prices. Such over the top descriptions just aren't justified by the actual data.

Each of these 4 utility companies supply electricity, and, in some cases, natural gas to their customers. Some still use coal to generate electricity. All have some level of renewable generation capability and all have plans to add to that. NEE in particular has a lot of renewable capacity, so it is ironic that MHF Trader claims all of their businesses will be disrupted by alternative energy distribution. He offers no evidence that centralized electrical power distribution will be significantly challenged in the next 10 or so years. In fact, the use of natural gas is likely to increase and its use to generate electricity is assured. Current battery technology assures that both wind and solar power generation will need to be supplemented by a more demand-based fuel source like natural gas for years to come.

If I buy the premise that utility share prices are likely to decline, should I short them?

Okay, for argument's sake, let's say that utility share prices are going to decline by a significant amount sometime soon. Is that a reason to start shorting utility stocks of the ETF XLU? I don't think so.

Investors are familiar with going long on a position. Basically there is an opportunity cost if your investment thesis doesn't pan out or work as well as you expected. And there is the risk that you could lose some or all of the money invested. As a dividend growth investor, even if I am wrong about how much the dividend will increase, I will still get paid some dividends as well. The long investment thesis depends in part on the fact that over the long term, most stocks go up in price, thus, making it easier to buy low and sell high.

When you go short a stock, you also are planning to take advantage of selling at a price higher than you purchased, you are just going to do those two actions in the opposite order. To get the shares you will sell, you borrow them (and will eventually have to return them). Your broker doesn't just lend you these shares out of the goodness of his heart, he charges you for that (think rent). So unlike being long a stock where waiting has only opportunity costs, you get charged more as you wait for the stock to get where you want it when you are in a short position. Also, any dividends that the company gives out while your short position is still open have to be matched by you (because two people think they own the shares and expect the dividend, but the company only pays one of them the dividend). Finally, in a short position, the potential loss is theoretically unbounded. What that means, is that since to close the position you have to buy the shares back, you have no limit on what that price might be. In reality, your loss will be limited by how much pain you are willing to take before you close the position.

So when I am thinking about shorting a stock, I need to know more than just that the price is going down. Just knowing that the price should go down some amount doesn't tell me all I need to know. First, I need to know when I should open the short position. If the target price is $20, it's a big difference if I open the short position when the stock is $30 or $60. So I want some information on how to figure out the best time or price to open. MHF Trader doesn't give a clear answer to this question, the best I can figure (based on his statement that we just passed the ex-div date for the dividend) is now. That isn't fatal to the recommendation, but it is less than ideal.

The next thing I want in a short recommendation is an explanation of the catalyst and why it will push the price down while my short position is open. MHF Trader presents several catalysts that very well could push share prices down, but there is no immediacy to them. Sure, one can argue that they will push the price down eventually, but who knows if it will be during the time I have the short position open.

The final bit of information I want is I need to know when to close. MHF Trader is quite clear on this issue. Close before the next ex-div date, so you don't have to pay out a dividend. I give him lots of points as this is a clear signal, can't be missed and can be seen well ahead of time.

With the information given, I don't see that selling short is worth the risk. Share prices are still increasing, the 10 year Treasury rate is certainly not doing much increasing (last I looked it was down). Given less than 3 months to allow increased interest rates to have an impact, I think the risk is too great for the probable reward. If an investor wants to try and benefit from a possible price decline in XLU or any of these utilities, I'd recommend buying a put with an expiration date of next January or so. Buying a put will both limit your loss and give you more time for the price to fall.

Conclusion

Utilities are not in any peril over the next 10 years. And even if they were, MHF Trader doesn't offer enough information to make shorting them anything but a risky bet.

I have bought more of D and DUK recently. They are currently selling at a good price, and rather than looking to short them, I think dividend growth investors should buy shares. NEE is a little expensive at this point, but it's not horribly over-priced. SO has some issues with its Kemper plant and some of its nuclear power plant projects, but still could be a good investment.

Note: I hope you all got something out of this article. I do appreciate the time you took reading it. If you are one of those who follow me here, I appreciate it; if you'd like to include yourself amongst those individuals, please hit the "Follow" button next to my name as well as following other contributors whose work you enjoy. As always, please leave any feedback and questions you may have in the comments below.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended. The price I call fair valued is not a prediction of future price but only the price at which I consider the stock to be of value for its dividends.

Disclosure: I am/we are long D, DUK, SO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.