Seeking Alpha

What To Do When An Entire Industry Becomes Overvalued

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Includes: ARTNA, AWK, AWR, CTWS, CWT, D, DTE, MSEX, SJW, SO, WEC, WTR, YORW
by: Robert & Sam Kovacs
Summary

Water utilities have had a great run in the past 12 to 18 months.

They have become extremely overvalued as a consequence.

I suggest steps that investors can take given the exceptional circumstances.

Written by Sam Kovacs

In the past days, I analyzed 4 different water utilities. I intended on writing more articles covering 5 more water utilities. But analyzing each of the 9 water utilities on my watchlist led me to the same conclusion: everything seems overvalued.

Source: Open Domain

In this article I will go over the numbers for the group of the 9 following stocks:

  • California Water (CWT)
  • Artesian Resources (ARTNA)
  • American States Water (AWR)
  • The York Water Company (YORW)
  • American Water Works (AWK)
  • Connecticut Water Service (CTWS)
  • Middlesex Water (MSEX)
  • SJW Group (SJW)
  • Aqua America (WTR)

I will also suggest how dividend investors can approach their holdings in water utes.

The current state of water utilities

In the following table, You will see data for all 9 water utilities we will be focusing on.

Source: mad-dividends.com

The first thing we remark is that these stocks, while they all pay dividends, their dividend yields are between 1.39% and 2.67%.

As a dividend investor, I have no problem investing with stocks which have low yields if and only if dividend growth potential is enormous. Below 2% I need high double digit dividend growth.

Yet a look at the next column suggests that dividend growth has been modest during these 5 past years with dividends growing between 3 and 12% annually depending on the stock. Furthermore none of these stocks have a buyback program. To the contrary some even have negative buyback yields: they've been emitting more shares.

The low yields seem surprising and might be an indication of widespread overvaluation in the industry.

This is confirmed somewhat in the next two columns: value and momentum.

Using our Value score shows that except Artesian resources, all other stocks have a Value Score below 50 / 100, which means they are more overvalued than the median US stock, based on multiples such as P/E, P/S, P/CFO, dividend yield and buyback yield.

On the other hand the momentum scores of the whole sector are stellar. Artesian Resources is once again the exception here, but all other stocks have better momentum than at least 70% of all US stocks.

Water utilities have had a great run as a group during the past 12 months. But in the process, they have all become overvalued and as a consequence don't offer attractive dividend yields given the low dividend growth potential.

Therefore, at current prices, future returns for water utilities seem somewhat limited.

This is confirmed when we check the Stock Strength Scores of these stocks. Stock strength combines our value, momentum, financial strength & earnings quality scores to assess a stock's potential for capital appreciation in the next few quarters.

Except SJW, none of these 9 water utilities have a Stock Strength Score above 50 / 100. This means that nearly all water utilities have less potential for capital appreciation than the median US stock.

Investors need to acknowledge that there are currently no attractive opportunities to purchase water utility stocks. The first logical step for investors is to stop accumulating shares of water utilities.

However, this won't limit your exposure to the industry. Given that all these stocks have shown very good price appreciation in the past 12-24 months, it is most certainly likely your positions in these names come with hefty unrealized capital gains.

Is paying capital gains tax a big deal?

If you hold the stocks in a tax sheltered account, selling stocks to realize the capital gain will have close to no consequences on the value of your portfolio.

However, if you hold the stocks in a taxable account, selling the stocks would make you incur capital gains tax. It is important to not get paralyzed at this point.

As dividend investors, our goal is to maximize our dividend income potential, and paying capital gains taxes doesn't necessarily stop us from doing this.

Benjamin Franklin said that "there are only two things certain in life: death and taxes".

Humanity has been battling against these two fatalities forever. Over 2,200 years ago, Qin Shi Huang, the first emperor of China, put out an executive order to search for an elixir of life. Today, Silicon Valley titans are pouring billions into researching how to tweak the human body so that we can live forever.

And while we haven't yet found a way to cheat life eternally, as a civilization we are continually finding ways to squeeze a few more years out of life. Just look at the chart below from the UN population prospects report.

Source: UN Population Prospects

Over the course of 100 years, it is expected that life expectancy will have increased by 75% across the world.

Battling death, or at least pushing it back, is a laudable goal. Cheating the taxman on the other hand isn't. It goes without saying that we do not condone tax evasion. It is simply not worth the risk. Wire fraud can carry a jail sentence of up to 20 years.

So while we continue to battle death, we need to accept taxes. Once we accept that they are a reality of modern society, we can start to think about them rationally and incorporate them into our analysis and decision process.

Calculating the Yield on Sale of your positions

In a recent article of mine -"Yield On Cost Is An Absurd Metric" - I presented the formula of a dividend metric we use: Yield On Sale (or YoS for short).

Investors will want to calculate the yield on sale of their water utility stocks.

YoS represents the yield at which you would need to reinvest the proceeds of selling a dividend stock to maintain your current income, taking into account capital gains tax.

There is very little chance that YoS catches on as a popular metric, given that calculating it requires using a formula which reminds me of corporate finance lectures in business school.

The formula is as follows:

Yield on Sale = annual dividends / ((price - avg cost) * (1 - tax %) + avg cost)

By applying this formula to one's water utility holdings, dividend investors get a major insight. They know at which yields they will need to reinvest the proceeds of a sale to maintain constant dividend income.

For example, let's say you own California Water Services. Let's assume you bought it 10 years ago for $18. The stock is currently at $57 and pays out $0.79 in dividends per year.

If you pay 40% in capital gains tax, your YoS would be

$0.79 / ( ($57 - $18) * (1 - 40%) + $18 ) = 1.9%.

For you to consider selling your position in CWT, you'd need to have a replacement stock lined up which yields at least 1.9% for you to maintain your dividend income.

Note that YoS is positively correlated to both the size of your capital gain, and your capital gain tax rate.

Finding replacement stocks for your water utilities

When we're trying to find a replacement for our dividend stocks, the first thing we do is look for better opportunities among the stock's peers. In the rare cases -like this one-where there are no attractive stocks within the same industry, we look at other industries within the same sector.

In this case, we'd look at power utilities. A quick overview of power utilities shows that they yield between 1.79% and 4.46%.

Source: mad-dividends.com

This suggests that there most likely will be replacement stocks which not only will be able to replace your dividend income but maybe even increase it.

A few months back we covered power utilities extensively. Since then, most have appreciated quite a bit. We suggested buying 4 different utility stocks:

At current prices, I wouldn't necessarily advise to accumulate any more shares of WEC or SO. Robert owns SO, I own WEC. I have no intention of selling WEC because it will be very hard for me to find better opportunities without either reducing my exposure to utilities or concentrating my portfolio into less names, which I don't want to do.

On the other hand, DTE, which was my favorite utility stock pick in spring, has "only" appreciated 7% since May, while the S&P 500 has declined 0.5% since. Dominion is only slightly up since our article.

It is becoming extremely hard to find attractive opportunities across utilities, but we believe investors would be well served by investing in either DTE or D to replace their water utilities.

Let's go back to the example where your Yield on Sale for CWT is 1.9%. By selling your shares and investing the proceeds in DTE, you'd increase your dividend income on the position would instantly increase by 51%.

Investing in D would increase your income by 145%. Obviously the increase in income shouldn't be the only factor to be considered. DTE has higher potential for dividend growth than D, and arguably more potential for capital appreciation. Investors would be well served by doing their own due diligence, taking in their personal goals and objectives. You can read our article "Dividend Investing Strategy For Individuals Like You And Me" for a few pointers of what to consider.

Final thoughts

Water utilities have become overvalued. So much so that I wouldn't advise purchasing or even keeping any exposure to the industry at current prices, especially when investors can transition into relatively undervalued power utilities, which have higher dividend yields and better potential for dividend growth.

Capital gains tax shouldn't be a break to managing your portfolio efficiently and realizing value when a whole industry becomes extremely overvalued.

If you found this piece interesting then click on the orange follow button which is located at the top of this article to receive free notifications when we next publish an article analyzing dividend stocks.

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