Friday, July 12, 2013

Lights Out for Utility Stocks?

Yesterday I went to hear Brian Chin, utility analyst at Merrill Lynch. 

I have followed Brian's work for a number of years, first while he was at Citigroup and now at Merrill.  His analysis is always thoughtful, and he is not afraid to take a non-consensus stand.

Utility stocks were the rock stars of the stock market in 2011, returning nearly +20% while the S&P gave a meager +2%.  Investors flocked to utilities in search of high dividend yields, and drove valuations to historic highs.

Since then the group has struggled.  There are several reasons:
  1. In a world of low interest rates, utility commissions are granting less generous rate increases.  Consolidated Edison, for example, recently filed for rate increases that would give the company a +10% rate of return.  Their regulators, however, have proposed a+8.7% allowed return for the company - a significant decrease from the +10% to +12% returns granted a few year ago.  Other regulators around the country are following suit;
  2. Power usage remains low compared to the peaks of a few years ago.  Although the economy has gradually improved, industries that were heavy power users have not returned to peak production;
  3. Power pricing has become more competitive.  With reserve margins remaining relatively wide, companies are demanding more pricing concessions;
  4. Investor consensus remains almost uniformly bearish on the outlook for bonds.  Most believe that interest rates will continue the slow rise higher that began a year ago.  Higher interest rates nearly always lead to a period of poor performance for stocks that are bought primarily for their dividend yields, such as regulated utilities.
Although his livelihood is following the group, Brian is largely bearish on the stocks he follows.

He noted that while he was at Citi he rated only two of the 23 stocks he followed as "buys".  Under the Merrill system - which attempts to have a more normal distribution of buys/neutral/sell ratings - he has more buys, but only on a relative basis - he is essentially negative on the whole utility group.

What would cause him to change his views?

If the economy picked up steam, and growth rates surprise on the upside, Brian might be inclined to turn more positive.  Stronger growth could lead to more power usage, and mitigate some of the negative headwinds facing the group listed above.

But for now, at least, he would stay on the sidelines.