The MnM Portfolio Supplement – I Want To, But Can’t Purchase A Water Utility
Summary I outline my preference for water utilities. I review my analysis of the five water utilities listed as Dividend Champions on David Fish’s monthly publications. The current prices, yields, and historical dividend growth rates are unattractive as compared to other opportunities. A little background When I look over my MnM portfolio, last written about here , one of the key considerations I make is sector diversification. As I have built out the portfolio this year, it has come to my attention that I do not have any exposure to several sectors, including, but not limited to: utilities, telecoms, and financials (excluding REITs and insurers). I have been tempted to add positions in these sectors to round out the portfolio a little more. I hope to potentially do so in the coming year. That being said, I wanted to look a little bit deeper into utilities, as when I look at the overall utilities sector, represented by the Dow Jones Utility Average (^DJU), I see that it’s trailing the broader S&P 500 this year. (click to enlarge) Source: Yahoo Finance, 11 September 2015 It’s important to note that there are various types of utilities in the U.S. There are those that provide electricity, those that provide natural gas, those that provide water services, and some that provide a blend of these services, or others. A Quick summary of the regulated utility industry I am well versed with the regulated utilities environment, having grown up with a parent who worked in the industry, and spending some time in it myself. For those unfamiliar with how these companies work, a simple explanation is that utilities work with state and federal utility commissions to get rates approved to charge customers (end users of the electricity, gas, water, etc.) based upon a cost plus margin model. The utilities generally have to justify their capital expenditures to the commissions in seeking to be reimbursed for the costs (and consequently their margin). This model exists as utilities generally have a monopoly of service for their territories, meaning that other utilities are not able to offer up competing services. It’s too cost prohibitive. End users generally have only one provider option. As noted above, I do not currently hold any utility stocks, but if I were to purchase one down the road, my preference would be towards water utilities. Why do I have a preference for water utilities? When I take a step back from the fundamentals and technicals, I question whether in 25 years (or shorter) our current electric utilities will still operate in the same way. For example, if you were to tell me in 1995 that we would be seeing a huge shift away from coal within 20 years, I might have laughed at you. When I went to Germany back in 2012, to visit the country and experience Oktoberfest, I couldn’t help but notice that virtually every roof was covered in solar panels. As we speak we’re seeing a transformation in the US in terms of solar being increasingly cheaper, more available, and installed in a distributed (vs. centralized) manner, even as far north as where I live where we see weekly articles of the local utility Xcel Energy (NYSE: XEL ) fighting with solar providers over the size of solar gardens. Don’t get me wrong, I’m not calling for the death of utilities as we know it, but I do think that technological change will put pressure on the current distribution model, and could be a major challenge to growth (i.e. higher electricity sales). Now, there are obviously counters to these concerns, such as expanding populations and increasingly more powered devices (such as cars) across the US, but you cannot deny that things are changing. Some might argue that you could thank the EPA for that. To get back to my point, water is one thing provided by current utilities that I do not feel faces the same kind of technological threats to growth that the other utilities face. We will always need it, and it seems like climate change (whether you believe it or not) is negatively impacting the supply as well, as demonstrated by the droughts in California. Given all of this, water to me, is the most defensive, and thus the one resource I would most like to consider investing in. Why haven’t I bought in already? I looked through David Fish’s U.S. Dividend Champions list for Water Utilities and found there to be five within the dividend champions. Not a bad number. These include American States Water (NYSE: AWR ), California Water Service (NYSE: CWT ), Connecticut Water Service (NASDAQ: CTWS ), Middlesex Water Co. (NASDAQ: MSEX ), and SJW Corp (NYSE: SJW ), and they boast some impressive dividend streaks. (click to enlarge) Source: Price, P/E and Yield metrics courtesy of FASTgraphs.com, closing prices as of 10 September 2015. Dividend growth metrics courtesy of David Fish’s U.S. Dividend Champions spreadsheet updated 31 August 2015. When I took a look through their fundamentals, I have to stop my analysis right there. What disappoints me the most is that for the most part, the dividend increases have been barely above, or even less than the assumed 2% level of inflation, and not just over the last five years, but over the last ten years. American States Water, which has shown superior growth, is just too expensive to buy right now. Further, I personally have a mental “4% yield” requirement for both Utilities and REITs, meaning that is generally the minimum yield I want in order to enter into these securities. This is especially true as we enter a rising rate environment. None of them even come close right now. I would throw in a FASTgraph, but it doesn’t seem warranted. Conclusion I like water utilities in principle, and would love to have a more defensive play in my portfolio; but I just can’t justify owning one right now at their current multiples and stodgy dividend growth. The valuations on these stocks don’t seem to justify the lack of growth. I will keep tracking the securities, as I would like to own one at some point, but I need prices to come down and to see some more accelerated growth before I would jump in. Right now it seems that I could likely do much better with a telecom, such as Verizon (NYSE: VZ ), which is trading at a much lower multiple, pays a much higher distribution, and has grown dividends at a much higher clip. I have my eyes on Verizon, and hope to initiate a position in it at some point in the future. (click to enlarge) Source: FASTgraphs.com, closing price as of 10 September 2015 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.