With interest rates having been at historic lows for a good few years now, relatively high-yielding defensive shares such as Severn Trent (LSE: SVT) have become popular among many investors.
Indeed, the utility industry sector , which contains a number of such stocks, has been bid up due to the increased demand from investors, with some of its members commanding fairly demanding valuations.
However, Severn Trent still seems to offer decent value and, more importantly, significant upside potential.
For instance, it trades on a free cash flow yield of 5.5%, which seems to be generous when the Bank of England base rate is just 0.5%. Furthermore, last year’s figure was not a one-off: Severn Trent has delivered positive free cash flow in each of the last 5 years.
Indeed, a free cash flow yield of 4.5% would still be fairly generous and, were shares to trade on such a yield, they would be priced at 2130p, which is around 22% higher than the current price level.
Although gains of over 20% would be impressive, Severn Trent continues to offer a generous yield of 4.6%, so the total return from investing in the company could be nearer to 30%.
In addition, Severn Trent continues to be a potential bid target; especially for foreign investors who value the stability and predictability of its revenue and earnings streams.
A bid was launched earlier in the year and Severn Trent’s share price spiked to reach north of 2100p before falling back after the board rebuffed the approach.
Clearly, the board may take some convincing that a sale is in the best interests of shareholders, but the bid does, nevertheless, highlight two important points.
Firstly, Severn Trent is undoubtedly attractive at current price levels to potential suitors. The fact that the approach was rebuffed does not necessarily mean that other potential buyers will be put off and, as such, another bid could be possible while shares trade at less than 2000p.
Secondly, persistent bid rumours and the expectation of a bid can help to drive shares upwards, even if a bid never materialises. For instance, continued bid talk may lead to speculation on the shares that could allow investors to take advantage of an inflated share price to lock in profits.
Indeed, Severn Trent seems to have the potential to deliver a gain of 22% or more, while also offering a yield of 4.6% and the potential for further bid approaches.
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> Peter does not own shares in Severn Trent.