Retired With Money To Invest? Consider Playing Defense With Utility Stocks by Chuck Carnevale, F.A.S.T. Graphs
It is no secret that the stock market in the general sense is trading at a higher valuation than normal. On the other hand, I would argue that it’s far from bubble territory. Regardless, I must admit that finding attractive valuations is getting harder with each passing day. This is especially true for the conservative retired investor looking for safe sources of income in order to fund their golden years. But at the same time, that does not mean that good value or sound investments cannot be found.
In the same vein, many, if not most, of the best-of-breed blue-chip dividend growth stocks are also now fully valued. However, it’s important to point out that fully valued does not mean the same thing as dangerously overvalued. Instead, it implies that many of our best dividend growth stocks are not bargains today. For example, quality blue chips like Procter & Gamble or Kimberly-Clark offer dividend yields in excess of 3%, which is reasonably attractive given the current low interest rate environment.
The fact that both of those names are Dividend Champions and/or Aristocrats suggest that future dividend increases can also be rationally expected. However, since both of these names are trading at above-average premium valuations, it also indicates higher than normal risk and perhaps less than historical normal total return opportunities. To illustrate my point, I offer the following earnings and price correlated F.A.S.T. Graphs™ on Kimberly-Clark since 2003.
Utilizing the calculating feature of the research tool I chose a point (May 28, 2004) where Kimberly-Clark was trading at approximately the same P/E ratio of 19, as it does today. Then I ran my calculation out to a future point in time when Kimberly-Clark was trading at a fair value P/E ratio of approximately 15 (November 30, 2011) which I contend is inevitable. The total annualized rate of return of 3.96%, although positive, is not necessarily enticing.
Then in order to emphasize the value and importance of fair valuation, I conducted a second calculation exercise. Only this time, I waited until a time when Kimberly-Clark’s stock price had, in fact, moved into fair valuation territory (October 31, 2005) and then calculated the return up to the same future point when the company was again at fair valuation (November 30, 2011). The result of investing when fair value was present generated a 7% total annualized return, which is reasonable and acceptable for this high-quality blue-chip.
However, there are interesting points to consider and learn from conducting this exercise. Although waiting for fair value to manifest before I invested significantly increased my total annualized return, it simultaneously meant forgoing a couple of dollars per share of dividend income. On the other hand, this exercise illustrated that by being diligent about fair valuation I would have increased my annualized return while simultaneously reducing my risk. The importance of investing only when fair valuation is present should not be disregarded or overlooked.
Regular readers of my work will attest to the fact that I believe it’s a market of stocks and not a stock market. Therefore, even though I have postulated the notion that the stock market in the general sense, and blue-chip dividend stocks in particular, are currently fully valued to moderately overvalued, that is not to say that all stocks or all sectors are also overvalued. The remainder of this article will offer a look at five high-quality utility stocks that were recently overvalued but have since come into fair valuation territory.
Utilities High Yield and Fair Valuation
In the introduction I alluded to the fact that I believe common stocks will inevitably move to fair valuation. Modern finance theory would like us to believe that the market is efficient and, therefore, that stocks are always being priced properly. I disagree with that theory, but not totally. Instead of the market always being efficient, I believe that it is always seeking efficiency. In other words, stocks do become improperly priced from time to time, however, they will inevitably move into alignment with fair value in the longer run. This works the same if the market is overvaluing companies as it does if it is undervaluing companies.
The utility sector represents a current case in point. From approximately the fall of 2014 through the spring of 2015, utility stocks became moderately overvalued to a similar extent that we currently see with the Kimberly Clark example above. However, most utility stocks peaked in January, and over the course of the rest of this year the average utility stock has fallen approximately 15% to 20% off of their highs.
Unfortunately, there are many investors that would consider the utility sector’s recent poor performance a negative and look elsewhere. In contrast, I see the utility sector’s recent poor performance as the inevitable process of the market seeking efficiency and see opportunity. Stated more directly, this low-growth but high-yielding sector has gone from being previously unattractive to currently being fairly valued and attractive. Where others see risk, I now see opportunity.
Utility Stocks: Sometimes the Best Offense Is a Good Defense
There are a couple of facts regarding investing in utility stocks that I would like to simply mention here, and elaborate more on later in the article with specific examples. First and foremost, almost by definition utility stocks tend to have very low historical rates of earnings growth. Therefore, if bought at fair valuation, the capital appreciation component for the long-term buy-and-hold investor will correlate very closely to the company’s rate of change of earnings growth.
Consequently, there is not much of a margin for error because even a modest amount of overvaluation can significantly lower or even negate any potential future capital appreciation. Additionally, current yield will be lessened, and risk increased if you overpay for a utility stock even by just a little bit. As previously mentioned, this was the case for utility stocks just a few short months ago, but not anymore.
The common view about dividend paying utility stocks, which I personally share, is that they are high yielding stable investments with predictable earnings and low volatility. Therefore, utility stocks have long been considered a safe sector. However, it is worth repeating that utility stocks are by their nature not high total return investments. Instead, investors are usually attracted to utility stocks for their above-average current yields, consistent operating results and relative safety. In other words, investors should expect utility stocks to be defensive and stable investments that have consistent earnings growth and offer above-average dividend yield. With attractive value so hard to find today, this makes fairly valued high quality utility stocks worth considering.
5 High Quality, High Yielding, Defensive Utility Stocks for Today’s Uncertain Market
When your investing objective is for income, as is the case for many investors in retirement, generating the highest possible total return is not the highest priority. The more prudent focus turns to preserving your capital, while generating an attractive level of spendable income. This is a primary reason why investors have traditionally chosen bonds and other fixed income instruments.
When interest rates are at more historically