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Profiting from other people’s nervousness

As I’ve remarked before, there are opportunities to be had when whole sectors or industries fall out of favour with investors – arguably more so, in fact, than when individual companies do.
When individual companies fall out of favour, it’s usually for company-specific reasons, which may turn out to be more serious than first imagined.
With whole sectors, there’s often less need to focus on the travails of individual companies. Instead, it’s the broader picture that matters. The question for investors: why has a given sector fallen out of favour – and is that reasonable, and likely to be sustained?

Bargains galore

 We last saw this two years ago, when oil and mining shares slumped, with investors concerned about low oil prices, and weakening natural resource demand from China.
While I’d no idea how long it would take for the price of oil to recover, or for iron ore demand in China to pick up, I judged the slump in oil and mining-related shares to be an over-reaction.
As I’ve written before, I added to my holding of Royal Dutch Shell (LSE: RDSB) at 1,295p. Today, the company’s shares are changing hands at 2,599p. Engineering companies IMI (LSE: IMI) and Weir Group (LSE: WEIR) were bought at 773p and 777p. They’re now 1,391p and 2,189p, respectively.
In mining, I added to my holding of BHP Billiton (LSE: BLT) at 595p. The shares are now trading at 1,620p. And as with oil, mining-dependent engineering firms were hit hard. Shares in Fenner (LSE: FNR), bought at 146p, for instance, are now worth 481p.

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Tough times for utilities

Is something similar happening today, but in the utility sector? That was the question I asked myself over the New Year break, as I took a look at my portfolio, and updated a spreadsheet that I use for planning purposes.
Certainly, my few holdings in the utility sector are struggling. SSE (LSE: SSE), bought five years ago, is back at its purchase price. United Utilities (LSE: UU), bought at various points over the last two years, is under water.
Elsewhere in the sector, National Grid (LSE: NG) is trading on a forecast yield of 5.2%, Pennon (LSE: PNN) 4.9%, and British Gas owner Centrica (LSE: CNA) 8.6%.

Market nerves

It’s not difficult to see why utility stocks are suffering. An incoming Labour government might re-nationalise the water and electricity sectors, it has been suggested. Greater competition and tighter margins are predicted for the water industry.
The present government, through Ofgem, is actively pursuing the price capping of standard variable tariffs. Both Centrica and SSE have high proportions of their customers, around two-thirds, on just such tariffs.
The market, in short, is nervous, and utilities’ share prices reflect that nervousness. Meaning that bargains may be on offer.

Mr Market’s mood swings 

Is the market right to be nervous? Am I wrong to sense potential bargains in the sector?
Who knows? A diversity of opinion is what makes a market.
What I do know, having seen it many times before, over the years, is that the stock market often over-reacts, both on the upside and on the downside. Revered investor Benjamin Graham’s characterisation of ‘Mr Market’ (euphoric one day, doom-laden the next) has a large grain of truth in it.
And my suspicion is that here is yet another case of the market over-reacting to potential adversity for a sector.

Risk vs. reward

What to do? You’ll need to make up your own mind, of course.
But I shall be buying. I’ve already dropped some Centrica into my pension, and am inclined to buy into National Grid and Pennon as well.
For all the threats on the horizon, utilities should still offer stable income streams from largely captive customer bases. And on yields north of 5%, I’m prepared to shoulder some risk and uncertainty.

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Malcolm owns shares in Royal Dutch Shell, IMI, Weir Group, BHP Billiton, Fenner, SSE, United Utilities, and Centrica. The Motley Fool has recommended shares in Royal Dutch Shell, IMI, Weir and Pennon.

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