It was only earlier this year that investors piled into defensive stocks, such as National Grid (LSE: NG) and SSE (LSE: SSE), on fears of slowing economic growth and political uncertainty. Utility stocks are widely seen as safe investments and had become popular this year as attractive higher yielding alternatives to traditional bonds.
However, since the US presidential election, these shares have come under pressure. Donald Trump’s shock election victory and his proposed infrastructure spending spree sent global inflation expectations to their highest level in more than a decade. Together with the better-than-expected economic outlook in the UK and the plunge in the value of the pound, this means a further interest rate cuts in the UK is now unlikely and interest rates may rise sooner than expected.
So, should you take advantage of the recent share price weakness to buy into these unloved stocks?
Uncertainty
The fears which drove investors to these defensive stocks have not gone away. In fact, there is probably more uncertainty than ever before. After all, Brexit hasn’t actually happened yet. Also, Italy is due to hold a referendum on the constitution before the end of the year, with French and German elections to take place next year.
In investing, as in buying things in general, you’re naturally concerned about whether you’ll be paying too much for something that will be cheaper at a later date. As is always, it’s hard to tell if shares in National Grid and SSE may indeed be cheaper in the future, but valuations are already rather attractive right now.
Plus, if you decide to wait, you could miss out on their upcoming dividends and other distributions, which means you could potentially end up worse off in the longer run by waiting for a better price. Shareholders in both companies may be in line to benefit from special dividends or share buybacks following recent and upcoming asset sales.
Steady returns
Shares in National Grid have fallen by 19% since its July peak, and now trade at a forward P/E of 14.5. This compares favourably to its 3-year historical average forward P/E of 16.4. Its dividend is also attractive, with shares currently yielding 4.7%, beating the sector average of 3.7%.
This is all the more impressive given its low cyclicality and minimal commodity exposure. Because it gets nearly all of its revenues comes from regulated transmission and distribution businesses, it earns a “rent-like” return based on the value of its capital investments, as determined by its regulators.
Of course, regulators could reduce future returns. Each of National Grid’s businesses goes through a process of regulatory review every few years, which obviously provides a degree of risk and uncertainty. But following its major regulatory review in the UK last year, the company is largely free of regulatory uncertainty – the main exceptions being its relatively smaller New York and Long Island gas distribution operations.
Higher yield
SSE is slightly more risky, as it owns a mixture of power generation and regulated assets. This means SSE has more exposure to commodity prices than National Grid. Nevertheless, SSE still generates relatively stable cash flows year-on-year, especially when compared to pure-play electricity generators, such as Drax Group.
And importantly for income investors, SSE maintains an inflation protected dividend policy. SSE trades on a forward P/E ratio of just 12.2 and currently yields 6.1%.
