Sizing up the utility underdogs

Utilities haven’t delivered any meaningful growth this year, but the sector provides a relatively attractive dividend yield and predictable earnings stream - for now.

The only sector to have performed worse this year than utilities is the materials sector. Utilities have gained 3.03 per cent against a loss of 3.73 per cent for materials.

Lacklustre performance from the utilities sector simply can’t be attributed to the market favouring more exciting risk-on options given the stellar performance of the healthcare index in comparison. Movements in long-term government bond yields can in part explain the performance of the utilities sector, as too can the plausible reasoning of changes that are sweeping utility companies around the globe.  Advances in technology and changes to energy consumption patterns are one contributor. In addition, there are regulatory adjustments that will impact business models for utility companies.  

A recent Price Waterhouse Coopers report concluded 69 per cent of respondents in Asia indicate utility business models will be transformed by 2030 compared to the current market. Interestingly, Asian utility businesses were the leading region to expect significant changes. Based on this, it looks like things will be different for Australian utilities in the years to come.

For now, we know factors such as supply and affordability will continue to shape the utility industry. Specifically, utilities with a tilt to gas such as APA Group will have the opportunity to cash in on the intensifying demand for gas. While the repeal of the carbon tax should see electricity costs for retail users decline around 9 per cent, according to the Australian Competition and Consumer Commission, there is the possibility the cost to utility providers has in fact been more than this. If that is the case, the cost will need to be worn by either consumers or companies.

From an investment perspective, it is realistic to assume the domestic demand for energy will only continue to grow, placing utilities in a desirable position. However, when looking at the sector or individual companies the market must weigh up the total return – capital growth and dividend yield in conjunction with the level of risk assumed.

Irrespective of the pros and cons for utilities, it is a foregone conclusion returns from the sector will appear less attractive once the Federal Reserve begins to taper, sending the yield on the Australian 10-year government bond skyrocketing.

Graph for Sizing up the utility underdogs

As we can see, lower yields on the long term government bond (pink line) line result in higher prices for the utilities sector (white line). Conversely, higher bond yields bring lower share prices. While utilities haven’t delivered any meaningful growth in this year, as an investment option the sector provides a relatively attractive dividend yield and predictable earnings stream for now – APA Group yields 5.8 per cent and SP AusNet 6.9 per cent.  

The question for investors will simply come down to how the level of risk they are comfortable assuming for these returns.

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