Equity valuations remain near historic highs, interest rates are rising, the bull market and the economic expansion are aging, and a trade war is escalating between the U.S. and China. This represents a "risk-on" environment in which investors may be well-advised to take defensive cover, according to Michael Wilson, the chief U.S. equity strategist at Morgan Stanley, per a report in Barron's. Wilson is recommending the utilities sector right now, and these four stocks have overweight ratings from Morgan Stanley: American Electric Power Co. Inc. (AEP), PG&E Corp. (PCG), Public Service Enterprise Group Inc. (PEG), and XCEL Energy Inc. (XEL).
|Stock||Dividend Yield||Forward P/E|
|American Electric Power||3.7%||16.3|
|Public Service Enterprise||3.4%||16.0|
Source: Barron's; data as of the open on June 20; forward P/E based on consensus EPS estimate for 2019.
Wilson recently upgraded the utilities sector to overweight, per Barron's, based on his expectation that the yield on the 10-Year U.S. Treasury Note is reaching a top, coupled with relative earnings breadth in utilities that is improving. By contrast, he notes that earnings growth rates are peaking for the S&P 500 Index (SPX) as a whole.
The PG&E Story
PG&E suspended its dividend in December, in the aftermath of northern California wildfires in October for which it has been blamed, and which may trigger huge claims for property damage that exceed its insurance coverage. According to a June 11 report from Morningstar Inc., as made available by Morgan Stanley to its clients, total claims could reach $10 billion, representing a worst case scenario of $13 in lost value per share. While warning that these wildfires could represent a "long overhang" on PG&E shares, with the dividend likely to remain suspended through 2019, Morningstar nonetheless assigns a fair value of $53 per share to the stock, nearly 33% above its opening price on June 20.
Meanwhile, Morgan Stanley has a price target of $58 for PG&E, 45% above the June 20 open. They project an average annual EPS growth rate from 2017 through 2020 of about 4%, roughly in line in consensus estimates. In a June 20 research report on PG&E, Morgan Stanley presented an in-depth analysis of the largest northern California fire, the Tubbs fire. They conclude that "there is a significant probability that PG&E either did not cause the fire, or if its equipment did cause the fire, it likely did not violate any vegetation management requirements."
The Fund Option
Rather than investing in individual utility stocks, investors who buy into Wilson's thesis might consider a utilities fund instead. The Reeves Utility Income Fund (UTG) is a closed-end fund that focuses on delivering dividend yield while reducing risk, per another Barron's article. The fund is diversified beyond electric utilities, buying telecom providers and interstate gas pipeline companies as well. It also can place up to 20% of its portfolio in other low-risk, high-yield companies outside its broadly-defined utilities universe.
Barron's indicates that the fund has delivered an annualized total return of about 11% during the past 10 years, versus 6.6% for the MSCI World Utilities Index. As co-manager John Bartlett told Barron's, "the outlook for utilities really remains very strong. Most of these companies have the ability to deliver growth around 5% to 7%. They have a dividend yield in the mid-3%."
The Bearish View
As long as interest rates continue to rise, there will be continued downward pressure on the prices of bond substitutes such as REITs and utility stocks, The Wall Street Journal warns. The S&P 500 Utilities Sector Index (S5UTIL) was down by 4.7% for the year-to-date through June 19, per S&P Dow Jones Indices. As the Federal Reserve accelerates its program of monetary tightening, the Journal notes, declines in the shares of interest rate sensitive stocks such as utilities should accelerate as well. A mitigating factor not mentioned by the Journal is that dividend-paying stocks offer the prospect of future dividend increases, a feature not present with bonds.