Scalper1 News
Utility investors should be more afraid of declining interest rates than rising. History points to rate cycle turns in 2004-2007, 1993-2000, and 1986-1989. Overall annual total return for utility stocks during the previous three rates hike cycles was 7.5%. In July 2014, I penned an article investigating the effect of previous interest rate cycle upswings on share prices of utilities, and with the pending rate hikes anticipated to begin in just a few weeks, it may be time to revisit this topic. The premise of the previous article was to review the performance of some well known utilities stocks after the previous three turns in the rate cycle. History points to rising interest rate cycles of 2004 to 2007, 1993 to 2000, and 1986 to 1989. I will not reiterate all the finer historic points of the previous article, including the graphs of the respective yield curves, but will analyze stock performance over the time frames. As background, I suggest reviewing the previous article. Many investors believe utilities are negatively hurt by rising rates. The most common reasoning is: •Higher rates increase interest costs for utilities and the capital-intensive nature of their business makes profits more sensitive to leverage expense. In addition, weak share prices reduces the effectiveness of equity raises to fund capital expenditures, along with raising the cost of the debt portion of billions in cap ex budgets. •Higher rates cause income-oriented investors to gravitate to bonds where principal risk is perceived to be lower. •If interest rates are increasing to stem the tide of rising inflation, utility operating costs, such as coal fuel costs, will also increase along with labor cost pressures. A traditional cost-push inflation cycle could be distressing to more than just a few utilities. Yes, corporate interest costs go up as new borrowings reflect current yield conditions. However, interest expense is part of operating expenses that are incorporated in most rate decisions. While there is a delay between cash out due to greater interest costs and inclusion in rate decisions, the higher expense is usually passed on to customers. While income investors will gravitate to safer bonds as their yield rises, selectively reviewing top quality utilities with a higher spread to 10-yr Treasuries will mitigate downward pressure in stock prices. Currently, rising rates are not being caused by cost-push pressures but due to stronger economic growth. Stronger growth usually leads to higher energy demands. In addition, a large percentage of infrastructure growth and cap ex is upgrading older assets and accommodating new sources of green energy, which are not as sensitive to underlying population and economic growth. The age of sector ETFs is relatively short and most do not encompass the above listed time frames. For example, S&P Utility ETF (NYSEARCA: XLU ) started trading in Dec 1998. In order to evaluate utility stock performance during these periods, a list of some of more popular stocks was chosen. These include: Duke Energy (NYSE: DUK ), NextEra Energy (NYSE: NEE ), Dominion Resources (NYSE: D ), Southern Co (NYSE: SO ), American Electric Power (NYSE: AEP ), PPL Corp (NYSE: PPL ), and PCG Corp (NYSE: PCG ). Combined, these represent 45% of the current value of XLU. Below are two tables outlining each stock’s performance during the last three up cycles in rates. The first table lists the starting and closing price of each stock, the individual performance of its share price and the value of an equal weight holding for these seven firms. The Fed Fund Rate is listed as well. The second table relies on information from buyupside.com to calculate the overall total return for each stock, the number of days held, and the value of an investment of $10,000 at the start date. As most utility investors realize, returns from utility stock dividends is an important portion of total return, and an overriding reason for buying utility stocks. The table also compares these with the return of S&P 500. These tables support the strategy of buying potential weakness in utilities when investors mistakenly sell at the turn in the rate cycles. Many utility stocks have declined from their 52-week highs, with the most common reason being a fear of rate hikes. For example, Duke Energy is trading -24% below its 52-wk high and 1% over its low, NextEra Energy -12% and 8%, Dominion Resources -16% and 3%, Southern Co -15% and 10%, American Electric Power -15% and 6%, PPL Corp -11% and 17%, and PCG Corp -12% and 13%, respectively. If an investor were to buy as the total return table outlines, their investment would have been a total of $210,000 combined, $70,000 each cycle. The value of these investments at the end of the respective rate hike cycle would be $350,000, or a total annual return of 7.5% over the 8.5 year covered. Utility investors should embrace the beginning of the rate up cycle by not dumping their stock holdings. If anything, investors should be looking for bargains as others are fearfully selling. Author’s Note: Please review disclosure in Author’s profile. Scalper1 News
Scalper1 News