Tuesday, October 1, 2013

Lights Out on Utility Stocks

Merrill Lynch's utility analyst Brian Chin was in town yesterday.  Brian has been following the utility space for 12 years, and in my opinion is one of the better ones on the Street.

I have been generally bearish on the utility group in recent months, but I thought I should go hear if there were any reasons that I should change my mind.

In a word:  No.

Utilities face a number of fundamental challenges.

Demand for power has been declining slightly despite an improved economy.  Alternative energy sources have played a role in supplementing traditional sources for power, and this trend seems likely to continue. 

Meanwhile, utilities are struggling to deal with new tougher environmental rules.

Utility commissions have been gradually reducing the allowed rates of return.  In a low interest rate environment, and with many Americans struggling with little or no real income growth, it is difficult to justify granting 10%+ returns to local utilities. 

Meanwhile, utility stocks are trading at the higher end of their historic valuation range; yield-hungry investors continue to favor the group almost regardless of price.  Brian's work indicates that most of the stocks are overvalued by at least 10% relative to a variety of different metrics.

In our meeting yesterday, I asked Brian if there was any real reason to get interested in the stocks he follows (fortunately he has a sense of humor).  While he favors a few companies in the group (he likes PPL; NextEra and Pinnacle), in general he would agree that the group needs a major re-rating before considering to add to positions.