Why Severn Trent Plc Should Not Be In Your 2014 ISA

What should you look for when you’re considering how to allocate your annual ISA allowance?

The ability to invest up to £15,000 a year in shares and protect the profits against tax is something not to be sniffed at, so it pays to make the best use of it — and for me that means looking for companies that should be around and providing profits for their owners for decades.

Must-have products

water-256349_640So how about Severn Trent (LSE: SVT)?

Well, its product is water, and that really is something nobody can do without! Waste treatment is part of the company’s services, too and, of course, what goes in must come out — and somebody has to deal with it.

So why don’t I think Severn Trent is the one to pick?

Regulatory hardships

Well, the latest musings from Ofwat suggest that the water companies will come under increasing pressure over the next few years — up until 2020, in fact, during the lifetime of the next regulatory period. And of the two big suppliers — United Utilities is the other one — Severn Trent is looking the one most likely to crack.

The sector relies on its dividends for its attractiveness with income investors, and both companies pay handsomely. But even though cover by earnings is traditionally quite low in such a predictable business, the Severn Trent dividend looks very vulnerable — forecast earnings per share (EPS) for the next three years are actually lower than the expected dividend payouts!

Of course, dividends in lower-earnings years can be covered by debt, but the sector already carries high levels of borrowings, and earnings pressure will make that look less attractive too.

Earnings falling

And with a 15% fall in EPS predicted for 2014, Severn Trent shares are on a forward price to earnings (P/E) ratio of 22 on the current share price of 1,847p. That’s pretty high — United Utilities is on a P/E of 18 (but with forecast dividends covered around 1.2 times by earnings, and yields slightly higher), and the FTSE average currently stands around 17.

Now, I know it’s all about the long term and that short-term valuations are less important, but when we can see pressure on a company that will affect the next six years, and we can also see it’s the weaker of the two water candidates — well, I think it makes sense to drop it from our considerations and investigate United Utilities instead.

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Alan does not own any shares in Severn Trent or United Utilities.