As Trade Wars Loom, Utilities Combine Attractive Expected Returns, Historically Low Betas and Limited Exposure to International Markets

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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March 26, 2018

As Trade Wars Loom, Utilities Combine Attractive Expected Returns,

Historically Low Betas and Limited Exposure to International Markets

The Trump administration’s recent action to impose tariffs on steel, aluminum and a range of exports from China have triggered threats of retaliation from the European Union and China, which together account for 27% of the United States’ total exports. Stocks of companies reliant on international markets have weakened markedly in response. In this note, we examine which of the defensive sectors in the U.S. equity market provides the greatest protection against the market volatility resulting from the administration’s actions. We find that (i) in almost all of the significant market downturns since 1994, utilities have outperformed both the S&P 500 and other defensive sectors (telecom, health care, consumer staples, REITs and MLPs) and (ii) utilities were particularly effective defensive investments during downturns triggered by global events, recession fears or financial crises.

The historical outperformance of regulated utilities during market downturns driven by global concerns, combined with the sector’s robust expected returns due to strong rate base growth, render utilities particularly attractive defensive investments in the current context of rising international trade frictions. We forecast ~7.2% compound annual growth in the industry’s aggregate electric plant rate base over 2018-2021, a pace of growth historically consistent with ~4.5%-5.0% growth in earnings per share. Given the sector’s average dividend yield of 3.8%, we would expect ~8.3%-8.8% compound annual shareholder returns, absent a change in the sector PE. By contrast, the forward earnings yield of the S&P 500 is 5.9%; adding expected inflation of 2.1%, based on the difference in yield between 10 year Treasury bond and TIPS, investors appear to expect long run nominal returns of ~8.0% on the equity market as a whole, again assuming no change in P/E. Adding regulated utility stocks to a diversified equity portfolio can thus mitigate the portfolio’s exposure to trade-related risks without sacrificing expected returns.

Exhibit 1: Average Outperformance vs. the S&P 500 of Indices of the Principal Defensive Sectors (1) During the Largest Market Downturns, 1994-2017

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1. NASDAQ PHLX Utility Index (UTY); Dow Jones U.S. Telecommunications Index (DJUSTL); Dow Jones U.S. Heath Care Index (DJUSHC); Dow Jones U.S. Consumer Goods Index (DJUSNC), Dow Jones U.S. Select REIT Index (DWRTF); Alerian MLP Index (AMZ).

Source: Bloomberg, SSR analysis

  • Utilities’ historical outperformance during market downturns triggered by global events likely reflects the exclusively domestic and highly regulated businesses of the overwhelming majority of U.S. utilities; these have insulated the sector from the impact of recessions abroad, foreign financial crises and geopolitical conflict.
    • The most internationally exposed defensive sectors, consumer staples and health care, have underperformed utilities significantly during market downturns triggered by global events, by an average of 690 and 730 basis points, respectively.
    • Telecoms and MLPs, which broadly resemble utilities in their domestic focus and regulated operations, performed better than the internationally exposed defensive sectors but still underperformed utilities, by 450 and 570 basis points, respectively.
      • Added uncertainty for MLPs from the recent FERC decision on the treatment of taxes at MLP-owned pipelines will likely render MLPs even less effective as defensive stocks until the controversy is resolved.
  • Furthermore, regulated utilities have historically outperformed other defensive sectors during downturns brought on by the fear of a U.S. recession.
    • During recession-driven downturns, utilities’ outperformance has exceeded that of the MLP sector by 220 basis points, on average, and health care and consumer staples by 340 and 380 basis points, respectively (Exhibits 1 and 5).
  • During downturns brought on by financial crises, the outperformance of the utilities relative to other defensive sectors has been particularly strong: 480 basis points relative to the telecom sector and 530 basis points relative to consumer staples (Exhibits 1 and 6).
    • In recent years, several financial crises have had their origins abroad (see Exhibit 8), enhancing the appeal of domestically focused regulated utilities as defensive holdings.
    • During these international financial crises, moreover, investors have sought the safety of U.S. Treasury bonds, driving long term rates down and utility valuations higher.
    • Risk aversion has also tended to strengthen the dollar relative to other currencies, reducing the value for U.S. based investors of the foreign earnings of internationally diversified health care and consumer staples companies.
  • The historical outperformance of regulated utilities during market downturns driven by global concerns, combined with robust expected returns due to strong rate base growth, render them attractive defensive investments in the current context of rising international trade frictions.
    • Based upon an analysis of U.S. regulated utilities’ capex plans, depreciation rates and prospective deferred tax liabilities, we forecast ~7.2% compound annual growth in the industry’s aggregate electric plant rate base over 2018-2021.
    • This growth in rate base should, in the medium term, drive commensurate growth in regulated earnings. Based on historical rates of earnings dilution during periods of similar rate base growth, and the slower growth from non-plant components of rate base, we expect our forecast growth in electric plant rate base of 7.2% p.a. over 2018-2021 to drive 4.5%-5.0% compound annual growth in earnings per share.
  • Given the sector’s average dividend yield of 3.8%, we would expect 4.5-5.0% annual growth in earnings per share to be consistent with ~8.3%-8.8% compound annual shareholder returns, absent a change in the sector PE.
  • We view the 8.3%-8.8% expected return on U.S. regulated electric utilities to be highly competitive with prospective returns on the S&P 500. The forward earnings yield of the S&P 500, based on 2018 consensus EPS, is currently 5.9%. Adding the expected inflation rate of 2.1% implied by the difference between the yield on 10 year U.S. Treasury notes and 10 year TIPS, investors appear to expect long run nominal returns of ~8.0% on the equity market as a whole, again assuming no change in P/E.
  • While regulated electric utilities thus appear poised to offer returns competitive with the broader market, the trailing 12-month beta of the sector is only 0.26 – a historically low level and just over half the 30-year beta of 0.48 (Exhibit 10).[1]
  • In conclusion, given the current environment of rising international trade frictions, we believe that adding regulated utility stocks to a diversified equity portfolio can reduce portfolio volatility without sacrificing expected returns.

Exhibit 2: Heat Map: Preferences Among Utilities, IPP and Clean Technology

 Source: SSR analysis

Exhibit 3: Relative Performance vs. the S&P 500 of Indices of the Principal

Defensive Sectors during the Largest Market Downturns, 1994-2017 (1)

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1. Includes all market downturns over 1994-2017 lasting less than 6 months and where the decline from

peak to trough was larger than 8.25%, equivalent to two standard deviations of the 30 day returns for the

S&P 500 since 1994.

Source: Bloomberg, SSR analysis

Exhibit 4: Relative Performance of the Principal Defensive Sectors during

Market Downturns Due to Global Events, 1994-2017 (1)

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1. See Exhibit 8 for list of events.

Source: Bloomberg, SSR analysis

Exhibit 5: Relative Performance of the Defensive Exhibit 6: Relative Performance of the Defensive

Sectors during Market Downturns Due to Fears of Defensive Sectors during Financial Crises,

Recession, 1994-2017 (1) 1994-2017 (1)

 

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1. See Exhibit 8 for list of events. 1. See Exhibit 8 for list of events.

Source: Bloomberg, SSR analysis Source: Bloomberg, SSR analysis

Exhibit 7: Largest Market Downturns, 1994-2017, & Their Principal Contributing Factors (1)

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1. Includes all market downturns over 1994-2017 lasting less than 6 months and where the decline from peak to trough was larger than 8.25%, equivalent to two standard deviations of the 30 day returns for the S&P 500 since 1994.

Source: Bloomberg, SSR analysis

Exhibit 8: Relative Performance of the Defensive Sectors during the Largest Market Downturns, 1994-2017 (1)

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1. Includes all market downturns over 1994-2017 lasting less than 6 months and where the decline from peak to trough was larger than 8.25%, equivalent to two standard deviations of the 30 day returns for the S&P 500 since 1994.

Source: Bloomberg, SSR analysis

Exhibit 9: Historical and Estimated Growth of Aggregate Electric Rate Base of U.S. Investor Owned Utilities (1991-2021E) (1)

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1. 2017-2021 growth estimates reflect the announced capital expenditure plans of the publicly traded investor owned utilities in the U.S. that have provided such forecasts in their SEC filings and investor presentations. The aggregate electric rate base of the companies providing such capex forecasts is equivalent to approximately 80% of the aggregate electric rate base of the U.S. investor owned utilities as a whole.

Source: FERC Form 1, SEC 10-Q, SNL, SSR analysis

Exhibit 10: Beta of the Philadelphia Utility Index Relative to the S&P 500 (1)

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1. The Philadelphia Utility Index is comprises primarily regulated electric and regulated electric and gas utilities.

Source: Bloomberg and SSR analysis

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. To estimate the beta of the publicly traded, regulated electric utilities in the United States, we have calculated the beta of the Philadelphia Utility Index (UTY), which is primarily comprised of regulated electric utility stocks. 
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