With global markets likely to rebound in the coming months, it is the less defensive utility stocks ...
With global markets likely to rebound in the coming months, it is the less defensive utility stocks that offer the best growth going forward.
The European utilities sector has outperformed most major stock markets since 1 April 2002, according to SchroderSalomanSmithBarney (SSSB).
'Our view is this is unlikely to continue and we think some of the more defensive utility stocks are now fully valued,' says Daniel Martin, senior analyst at SSSB. 'United Utilities, Kelda, awg, Pennon and Scottish 7 Southern are all trading at or above our price targets.'
Martin highlights Italgas, Red Electrica, Severn Trent and Snam Rete Gas as cheap defensive stocks.
'Our view is markets are unlikely to remain in their current shell-shocked state and the economic news remains broadly positive,' he says. 'If this is the case, an underweight position in the sector is the correct stance and the least defensive utility stocks may be the best performers in the second half of 2002.'
Where utilities have done well has tended to be in their domestic markets. It is when these companies diversify investments outside of their domestic markets, especially where it gives them exposure to Latin America, that problems arise, he notes. Spain's Endesa and French water treatment and electricity distribution company Suez, for example, both have exposure to Brazil.
Alessio Falino, utilities research analyst at Barings, says: 'You could argue they look cheap but the Latin American situation is still looking dodgy, with noises being made about the electricity liberalisation not working well. We like E.ON because the majority of its business is in Germany and it is looking to invest in the US. Given falling equity prices and a weakening dollar, it is a great time to do that.'
Gartmore is overweight UK utilities, neutral on Continental European utilities but underweight the sector in the US. Although utilities have generally outperformed in Europe, a fall in absolute terms is largely due to contagion from the US.
A number of companies have issued warnings on their regulated businesses, marketing or trading companies. For example, Williams, a gas pipeline company, has taken a recurring loss of $200m, says Julian Sinclair, head of global utilities at Gartmore.
'Essentially, there is a global average on utilities of 10 or 11 times earnings, with some higher and some lower,' says Sinclair, 'Investors have shown themselves reluctant to pay a 30% to 40% premium for something they perceive as an uncertain type of company. They have tended to focus on regulated utilities where the return on investment capital has been defined by the regulator. That has been the defensive side of utilities.
'Assuming steady GDP growth, you have a regulated return on capital. If you have trading and marketing businesses, you have risk on your balance sheet from that so it's different.'
'We are not taking a bet on the sector as a whole. We are bullish on the market and believe think there will be a pick-up so we don't want to be underweight. Given that the market is nervous, however, utilities is a safe place to be, so we are neutral.'
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