Thursday, November 8, 2012

What's Ailing Utility Stocks?

Last year, in 2011, utility stocks were the best performer in the S&P 500, returning almost +20% (including dividends) while the S&P produced a meager +2.1%.

This year, however, it has been a completely story.  As the above chart shows, utilities have badly lagged the broader market averages.  In fact, through the end of October 2012, the utility sector had been the weakest performer in the S&P 500 - a complete reversal from last year.

So what's going on?

Historically utility stocks have not fared well when interest rates have risen.  However, rates have generally fallen in 2012 - the 10 year Treasury yield was 1.9% at the beginning of the year, versus 1.7% today.

Could it be a potential rise in dividend tax rates?  Well, maybe.  Hugh Wynne at Bernstein wrote a piece earlier this week suggesting that the market is beginning to realize the negative impact that a rise in dividend tax rates will have on regulated utilities.

As a reminder, if Congress does not act before the end of the year, the maximum rate on dividend income will rise from 15% to 43.4% (39.6% top income tax bracket plus the 3.8% Medicare tax on investment income).  Capital gains rates, meanwhile, will rise from 15% to 23.8% (20.0% capital gains tax plus the 3.8% Medicare tax).

Wynne notes:

  • The expiry of the Bush tax cuts would create a 20 percentage point wedge between the tax rates on dividends and capital gains.
  • Regulated utility stocks, which historically have returned ~2/3 of their total returns to shareholders in the form of dividends, will be much more adversely affected by this change than other sectors with lower payout ratios and yields.

Wynne goes on to write that his calculations suggest that regulated utility stock could fall by as much as -20% from today's levels in the worst case scenario.

I'm not sure I agree.  Telecommunication stocks (AT&T and Verizon) have been strong performers this year (up +15% YTD) and they too are usually bought for their healthy dividend yields. Other sectors that contain high dividend payers such as consumer staples stocks have also turned in a respectable performance this year.

I would suggest that the threat of increased regulatory pressure on utilities is weighing heavily on the stocks this year.

If you look at the chart above, the path of the performance of the group almost directly matches the tug of war between the two Presidential candidates.  In particular, the spike in utility stocks matches very nicely with the bounce in the polls that Governor Romney enjoyed after the first Presidential debate.

But more recently, with the re-election of President Obama, the stocks have moved sharply lower.  Correctly or not, the Obama administration is widely viewed as being anti-coal.  Since half of our nation's electricity comes from coal-fired plants, perhaps the markets are anticipating tougher new environmental regulations in 2013, which will put significant cost pressures on the companies.

In short, the combination of higher dividend tax rates, and more regulation, have made 2012 a tough year to be an investor in utilities.