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United Utilities: Defensive attractions on tap

United Utilities is my pick of the sector and trades at a discount to peers, with a forward PE ratio of 6.8x, compared with Severn Trent and Pennon, which trade on 8.7x and 13.2x respectively.

A glance at the above chart of the FTSE 100 highlights the sharp falls experienced this week, as risk appetite has deteriorated amid the continued nervousness surrounding the global economy.

The blue chips moved lower last Friday, as GDP figures confirmed that the UK is still in recession, with GDP falling 0.4% for the third quarter. Analysts had predicted that growth in the economy would turn slightly positive, but the latest data raised fears the UK will not have an easy recovery. GDP has now been declining for six consecutive quarters, the longest period since records began in the 1950’s.

Mixed US economic data has also weighed on equities, with the conference boards consumer confidence index declining to 47.7 this month, which was considerably below analysts expectations and marked its lowest level since July. The termination of the cash for clunkers stimulus and downward pressure on wages led to the lower than forecast figure, which in turn raises concerns over US GDP data for the final quarter.

However, the GDP estimate for the third quarter came in at 3.5%, which was above expectations of a 3.3% rise and marked the first quarter of growth since the second quarter of 2008.

Financials have been hardest hit this week, with the likes of Barclays, Lloyds and RBS losing around 15% of their value in the past 10 days. The weakness comes as speculation surrounding various rights issues and potentially damaging EU legislation creates uncertainty over the sector. ING led the way lower as it was forced to split its insurance and banking units, which raised concerns that other financial corporations could be likely to follow suit.

Technical analysis shows that despite the recent weakness the upward trend remains intact. The moving averages are still inclining and support from the 50 day exponential moving average (NYSEMKT:EMA) is seen at 5040, with major support coming from the recent low at 4990.

However, the relative strength index (RSI) has broken below the 50 level and traded a fresh medium term low, which indicates that the momentum is escalating to the downside, as it nears oversold territory.

In summary, I remain with the truism that a trend remains in place until it is broken. Therefore, I regard the recent weakness as a period of consolidation of the longer term uptrend and should be seen as a buying opportunity. However, a close below 4990 negates this view, as a fresh medium term low would indicate that the trend has been broken and could trigger further rapid falls towards 4600.

Defensive stocks have outperformed the wider market this week, as investors have rotated a few funds away from cyclical high beta stocks that have risen a long way over the past six months. However, water stocks have been among the worst performers on the market in 2009, with the multi utilities sector down around 12% since the start of the year.

Concern over the upcoming review from Ofwat, the water services regulation authority, has restrained the sector since the regulators comments in July for a proposed average reduction in water bills of 4% in real terms by 2015. This compared to the water companies request for a 9% increase and this spooked the market as fears of lower revenue and profits may threaten the traditionally high dividends that these companies offer.

Recent broker comment suggests the market is now pricing in a dividend cut of around 35% for United Utilities (epic: UU.), which is the UK’s largest water company and I believe this pessimism is overdone.

Immediately after Ofwat’s draft review in July, United Utilities made a statement that they are maintaining this year’s dividend at 32.67p (7.4%) and that it expects to grow its dividend for 2009/2010 by 5%. Furthermore, next years dividend is almost twice covered by earnings, so even if it is reduced, I don’t believe it will be to the extent that the market is pricing in.

United Utilities is my pick of the sector and trades at a discount to peers, with a forward PE ratio of 6.8x, compared with Severn Trent and Pennon, which trade on 8.7x and 13.2x respectively.

The focus will now be on the 26th November when the regulator presents its final determination for the next five years. I believe that much of the gloom has been overdone and the sector should start to recover once the uncertainties surrounding the new regulations are confirmed.

As can be seen from the above chart of United Utilities the shares have performed extremely poorly over recent years, following a downward trend lower from a high of 800p at the start of 2007.

However, the shares appear to have found support at 429p and have bounced off this level on several occasions in the past three months. Furthermore, the oscillators are starting to turn higher, with the upward trending RSI suggesting that the buying momentum is building.

The moving average convergence divergence (MACD) histogram, which is a trending indicator, is also stepping higher and has moved into positive territory. In addition the fast MACD line has crossed over the slower signal line leading upwards, which indicates that a new uptrend could be underway.

In light of the above analysis of the FTSE and the strong technical and fundamental analysis discussed for United Utilities, I believe the shares could start to play catch up with the wider market.

At the time of writing the share price is 442.8p and my medium term opinion is for the shares to move higher. Near term targets are seen at 459.75p, 474p and 498.5p, with a tight stop loss marginally below the recent low at 426p, I believe it offers an attractive risk/reward basis.