The Motley Fool

A possible recession makes utility stocks attractive now

Defensive stocks in the tobacco, consumer goods, and utility sectors are regarded as being the best investments to own in an uncertain economic environment. Indeed, post-Brexit vote, stocks across these industries have outperformed the wider market as investors sought solace in their steady revenue growth and international operations.

Domestic utilities such as Severn Trent (LSE: SVT), United Utilities (LSE: UU) and Pennon (LSE: PNN) may prove to be even better investments if the UK falls into a recession during the next few months. You see, right now there are two significant threats are facing the UK economy. Firstly, inflation. As the value of the pound has fallen, goods and services imported from overseas will become more expensive, which will have a knock-on effect on the wider economy. Secondly, it’s widely believed that UK economic growth will grind to a halt as overseas firms pull investment plans during the next few months. So investors need to prepare for rising inflation and slowing economic growth. The best way to do this could be to invest in utilities.

Even in the deepest economic recessions, people still need access to water so if the UK’s economy starts to contract, Severn Trent, United Utilities, and Pennon are unlikely to report a noticeable decline in sales. What’s more, these utility providers are allowed to increase prices charged to consumers in line with inflation. Simply put, as the rest of the economy struggles with slow growth and rising prices, Severn Trent, United Utilities and Pennon will be able to continue to grow and increase profits. Other factors such as falling interest rates will only add to the positive effects felt by these utility providers.

Safety in dividends 

Dividends at Severn Trent, United Utilities and Pennon are all linked to inflation as well. 

For example, United Utilities has a dividend policy of targeting a growth rate of at least retail price index inflation each year through to 2020. Last year the company increased its full-year payout by 2%, which was based on the RPI element included within the allowed regulated revenue increase for the 2015/16 financial year. Severn Trent’s dividend policy is to grow the payout by at least RPI through to 2020. Pennon is targeting 4% growth per annum above RPI inflation to 2020.

The shares of these companies have many bond-like qualities, making them attractive to even the most risk-averse investor. There aren’t many other investments out there that support similar inflation-protected sustainable dividends.

At time of writing, shares in Severn Trent support a dividend yield of 3.3% and trade at a forward P/E of 23.8. Shares in United Utilities meanwhile trade at a forward P/E of 22.7 and support a dividend yield of 3.8%. Lastly, shares in Pennon currently yield 3.8% and trade at a forward P/E of 23.9. 

These utility providers may look expensive at first glance but their defensive nature and sustainable dividends, which are set to rise in line with inflation over the next five years, are worth paying a premium for in today’s uncertain environment. 

The worst mistake you could make

According to a study conducted by financial research firm DALBAR, the average investor realised an average annual return of only 3.7% a year over past three decades, underperforming the wider market by around 5.3% annually.

This underperformance can be traced back to several key mistakes that all investors make. To help you realise and understand the most common mis-steps, the Motley Fool has put together this new free report entitled The Worst Mistakes Investors Make.

The report is a collection of Foolish wisdom, which should help you avoid needlessly losing too many more profits. Click here to download your copy today.

Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.