Southern Company Is A Defensive Equity Stalwart

Summary

• SO has a long history as a low-beta income stock.
• SO has out-performed the utility indexes in recent years.
• The Wall Street consensus outlook projects around 9% total return.
• The market-implied outlook for SO is bullish, with low volatility.

Nejc Gostincar/E+ via Getty Images

Southern Company (NYSE:SO) is one of my favorite ultra-defensive stocks, with a beta of 0.47. SO’s trailing 1-year total return of 11.6% has soundly exceeded the return of the utilities industry over this period, but has delivered less than half the return of the S&P 500 (27%). The Utilities Select SPDR ETF (XLU) has a 12-month total return of 5.8%, slightly less than the 6.8% 12-month total return from the iShares U.S. Utilities ETF (IDU). SO has also returned substantially more than the utilities sector over the past 3 years.

12-month price history and basic statistics for SO (Source: Seeking Alpha)

With a forward yield of 4.2% and 5- and 10-year dividend growth rates that are almost equal (3.35% and 3.43%, respectively), using the Gordon Growth Model to estimate an expected return of 7.6% a year seems reasonable. This value is remarkably in-line with the trailing total returns over the past 5-, 10-, and 15-year periods (8.0%, 7.2%, and 6.8%, respectively).

I last analyzed SO in early February, almost 8 ½ months ago, at which time I gave the stock a bullish rating. Over the period since that post, SO has returned a total of 7.55% vs. 15.2% for the S&P 500.

Performance of SO vs. the S&P 500 since my last analysis (Source: Seeking Alpha)

Along with the fundamentals on SO, I also considered two forms of consensus outlooks. The first is the well-known Wall Street analyst consensus. In early February, the consensus rating was bullish and the consensus 12-month price target was 5.3%-10.3% above the share price at that time (which implied expected 12-month return of 9.6%-14.6% with the 4.3% dividend yield at that time). For a low-beta, low-volatility stock, this level of expected return is attractive.

The second form of consensus outlook that I look at is the market-implied outlook, which reflects the consensus expectations of the options market for a stock. The price of an option represents the market’s consensus estimate of the probability that the share price will rise above (call option) or fall below (put option) a specific level (the strike price) between now and when the option expires. By analyzing call and put prices at a range of strikes, all at the same expiration date, it is possible to calculate a probabilistic outlook for price returns that reconciles the options prices. This is the market-implied outlook. I have written an overview post for readers who would like more background on this concept. In early February, I characterized the market-implied outlook for SO through 2021 as mildly positive.

With the bullish Wall Street outlook and the slightly bullish market-implied outlook, along with a reasonable valuation, I concluded with a bullish outlook on SO. Today, with more than 8 months since I last analyzed SO, and an earnings report coming up on November 4th, I am revisiting this stock.

Wall Street Consensus Outlook for SO

ETrade calculates the Wall Street consensus using ratings and price targets from 7 ranked analysts who have published their views within the past 90 days. The consensus rating for SO is neutral and the consensus 12-month price target is 3.6% above the current share price. There is a lot of dispersion among the price targets, which reduces confidence in the consensus. Of the 7 analysts in the consensus calculation, 4 assign a buy rating and 3 assign a sell rating for SO.

Wall Street analyst consensus rating and 12-month price target for SO (Source: ETrade)

Seeking Alpha combines ratings and price targets from 18 analysts who have published their views in the past 90 days. The consensus rating is bullish, although the individual analyst ratings cover a wide range. The consensus price target is $67.06, 6.1% above the current share price.

Wall Street analyst consensus rating and price target for SO

(Source: Seeking Alpha)

Averaging the two consensus price targets, the expected 12-month price appreciation is 4.8%, for a total expected return of 9.0%. For a low-beta, low-volatility stock, this level of return would be attractive. The wide spread in the individual analyst ratings and price targets is, however, a bit of a concern.

Market-Implied Outlook for SO

I have analyzed the prices of call and put options at a range of strike prices, all expiring on January 21, 2022, to generate the market-implied outlook for the 3.2-month period from today until that expiration date. I have also analyzed options expiring on June 17, 2022 to generate the market-implied outlook until the middle of 2022. There is active trading in the options expiring in January, but far less for options expiring in later months. As a result, the outlook to mid-2022 should carry little weight.

The standard presentation of the market-implied outlook is in terms of a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for SO for the 3.2-month period from today until January 21, 2022

(Source: Author’s calculations using options quotes from ETrade)

The market-implied outlook to January 21, 2022 is clearly (negatively) skewed to favor positive price returns over this period. The peak probability corresponds to a price return of 3.8% over this 3.2-month period. Given the expected $0.64 dividend payment between now and January 21, 2022, the most probable total return for the next 3.2 months is +4.8%. This is a bullish outlook for SO. The annualized volatility derived from this distribution is 19.6%.

To make it easier to see the relative probabilities of positive and negative returns, I typically rotate the negative return side of the market-implied outlook about the vertical axis (see chart below).

Market-implied price return probabilities for SO for the 3.2-month period from today until January 21, 2022. The negative return side of the distribution has been rotated about the vertical axis

(Source: Author’s calculations using options quotes from ETrade)

With this view, it is clear that the probability of positive price returns is markedly higher than for negative returns of the same magnitude for a range of the most probable outcomes (the solid blue line is well above the dashed red line for the returns from 0% to 11% on the chart above). This view reinforces the bullish interpretation.

For large-magnitude returns (greater than +/-13%) for the 3.2 months period, there is a higher probability of negative outcomes relative to positive (the red dashed line is above the solid blue line for returns from 13% to higher values on the chart above). This is an expression of the negative skewness in the outlook. These are low-probability outcomes overall. We expect to see this type of behavior for stocks that pay out a large portion of earnings in dividends, like SO, which reduces the potential positive price appreciation.

Looking out to June 17, 2022, 8 months from now, the market implied outlook is qualitatively very similar to the view to January 21, 2022. The 8-month outlook is bullish, with a peak in probability corresponding to a positive return and consistently higher probability of positive returns relative to negative returns of the same magnitude. The expected annualized volatility derived from this distribution is 20.4%. This outlook also exhibits the elevated probabilities of loss for large-magnitude returns. As noted earlier, the small amount of options trading at this time horizon means that I don’t put much confidence in this outlook. That said, it is reassuring that this longer outlook is consistent with the view to early 2022.

Market-implied price return probabilities for SO for the 8-month period from today until June 17, 2022. The negative return side of the distribution has been rotated about the vertical axis

(Source: Author’s calculations using options quotes from ETrade)

The market-implied outlook for SO is bullish, with about 20% expected annualized volatility. This outlook is much more bullish than when I last analyzed SO in February.

Summary

Southern Company (SO) is a low-beta, low-volatility stock that has out-performed relative to its industry and generally in line with what is expected given the low beta. The company has a long and steady history of growing the dividend, as well. With a yield of 4.2% and 3.4% dividend growth rate, an expected total return around 7.6% is reasonable. The Wall Street consensus outlook for SO is neutral to slightly bullish, with expected 12-month price return of +4.8% (averaging the two versions of the Wall Street consensus that I look at), for a total expected return of 9%.

The market-implied outlook for SO is bullish, with expected volatility of about 20% (annualized). In general, for a stock to be a buy, I look for an expected 12-month return that is at least ½ the expected volatility. SO does not quite reach this level. There are, however, two mitigating factors that cause me to maintain a bullish rating on SO. First, the market-implied outlook is strongly bullish in terms of the relative probabilities of positive vs. negative price returns. Second, the low beta means that SO has positive diversification benefits beyond its standalone return.

Disclosure: I/we have a beneficial long position in the shares of SO either through stock ownership, options, or other derivatives. 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.