US Utilities: Don’t Overpay for Yield

Wednesday, July 25th, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

As short-term interest rates remain at or close to zero, investors starved for income should be wary of overpaying for yield, particularly when it comes to US utilities.

As I write in my new Investment Directions monthly commentary, I continue to prefer dividend funds and the global telecommunications sector for investors searching for yield. But some segments of the market – such as US utilities — are looking expensive and should likely be avoided.

I continue to hold an underweight view of US utilities for two reasons:

1.) Valuation: Investors have pushed US utility stocks up too far as US utilities currently look even more expensive than they were back in January. US Utilities are currently trading at nearly 15x earnings, versus an average since 1995 of around 14.5x. And the stocks are even more expensive when you compare their valuation to the broader market. As a regulated industry, utilities typically trade at a discount to the broader market. Since 1995, US utilities have traded at an average discount of roughly 25% to the S&P 500. Today, however, US utilities are currently trading at a more than 8% premium, the largest since late 2007.

2.) Profitability: The premium can’t be justified by US utilities being more profitable than in the past. In fact, the US utilities industry is currently less profitable than its long-term average. Return on earnings for US large cap utility companies is currently 10.5%, the lowest level since 2004.

So why are investors paying a near 10% premium to invest in a sector whose profitability is close to an eight-year low? The answer: US utilities have benefited from investors’ flight to safety and flight to yield. To be sure, if the market experiences a major correction, US utilities would likely outperform given their low beta (a measure of the tendency of securities to move with the market at large). However, absent a major correction, I believe a combination of stretched valuations and lackluster profitability suggests that US utilities are likely to continue to trail the market, even in a slow growth environment.

As I wrote in a recent post, my preferred vehicles for seeking yield are dividend paying equities, such as the iShares High Dividend Equity Fund (NYSEARCA: HDV), given its low beta and quality screen; the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE). For investors willing to take the added risk of sector exposure, I like the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA: IXP).

And for investors still looking for exposure to utilities, I continue to hold a neutral view of global utilities, particularly international ones available through the iShares S&P Global Utilities Index Fund (NYSEARCA: JXI).

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long HDV, IXP, IDV

Investing involves risk, including possible loss of principal. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility.  International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

There is no guarantee that dividends will be paid.

Tags: Amp, Beta, Cap, Chief Investment Strategist, Dividend Funds, Earnings, Global Telecommunications Sector, interest rates, Investment Directions, Investors, Ishares, Nbsp, Profitability, Russ, Segments, Tendency, Term Interest, Utilities Industry, Utility Stocks
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Bill Ackman and Hunter Harrison Discuss Canadian Pacific

Tuesday, May 1st, 2012

 
Bill Ackman, [$11-billion activist billionaire hedgie] on Canadian Pacific [proxy battle]

A snippet from the transcript:

Ackman: “Even if you take the earnings away, they’re still reported. the profitability of the company is worse than it was six years ago. the profit margin, the so-called operating of the business was worse.

CNBC: But on you calling BS, if you will, on these numbers, are you prepared to walk that back or do you think the numbers are real?

Ackman: Unfortunately right now we’re in the middle of a proxy contest. i don’t know who to believe. Let’s just stick with the reported numbers. By the way, if I got them wrong, I’m happy to admit I’m wrong.

CNBC: If the numbers are right, you will say you were wrong?

Ackman: Sure.

CNBC: There are a number of reports where the company has asked you to apologize and —

Ackman: if I’m wrong, I’m delighted to apologize. Unfortunately right now, the company realizes they’re losing so they want to create a side show out of a technicality.

CNBC: Who do people want? Do people want Fred Green to be CEO of the company going forward?

Ackman: The answer is no. Hunter, by the way, is the most decorated CEO in the railroad industry.

 
Hunter Harrison and Bill Ackman on Running a Better Railroad

Tags: Activist, Bill Ackman, Billionaire, Ceo, Cnbc, Earnings, Hedgie, Hunter Harrison, Nbsp, Profit Margin, Profitability, Proxy Battle, Railroad Industry, Running, Six Years, Snippet, Technicality
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Another Country in Europe to Avoid (Koesterich)

Tuesday, March 13th, 2012

While Greece is now cleared to receive a second bailout and Spain and Italy are facing lower borrowing costs, Europe is not yet out of the woods. Greece, for instance, still has unsustainably high debt levels, and Portugal’s rising yields are becoming increasingly worrisome.

Given these lingering issues, I recently advocated that investors avoid Spain and Italy, markets that are cheap for a reason. Now, I’m adding another country to the list of European markets to consider underweighting: the United Kingdom, a market that has its own issues separate from those of the euro zone.

Currently, equities in the United Kingdom appear overvalued, especially when you consider the numerous signs that the country is teetering on the brink of another recession. As of this writing, UK stocks are trading at a relatively rich valuation of 1.7x book value, higher than the 1.5x book value average for developed countries.

At the same time, economic conditions in the United Kingdom are deteriorating. Expectations for UK growth have decreased over the last six months, and UK corporate sector profitability has dropped since the end of last year. In addition, UK mortgage rates have increased and unemployment remains at a 17-year high, headwinds for an economy where household spending accounts for roughly 2/3 of gross domestic product.

While UK inflation is declining, it’s still elevated at 3.6%, a level well above both the Bank of England’s target rate and UK wage growth. Thanks to the United Kingdom’s relatively high inflation, it appears unlikely that the Bank of England will provide further quantitative easing in the near term, meaning the UK economy will have less growth support. Finally, the United Kingdom may be trying to reign in its deficit too quickly by raising taxes and cutting spending, potentially raising the risk of another recession.

So where should investors consider investing in Europe? I continue to believe that much of Northern Europe represents a good value for long-term investors and I particularly like Germany, the Netherlands and Norway (potential iShares solutions: NYSEARCA: EWG, NYSEARCA: EWN, NYSEAMEX: ENOR).

Tags: 7x, Bailout, Bank Of England, Brink, Corporate Sector, Debt Levels, Developed Countries, Economic Conditions, Euro Zone, European Markets, Gross Domestic Product, Headwinds, Household Spending, Profitability, Recession, Target Rate, Uk Economy, Uk Inflation, Uk Mortgage Rates, Uk Stocks
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Mega Caps: Where the Profits Are

Thursday, February 16th, 2012

As I recently pointed out, despite mega caps’ recent outperformance, the stocks remain cheap on both a relative and absolute basis.

Now, here’s more evidence to add to the case for mega caps. As I write in my new Market Update piece, the current discount on mega-cap stocks is particularly hard to justify given that these large companies continue to be extremely profitable despite today’s tepid economic environment.

In fact, as the chart below nicely shows, the return on equity (ROE) for the S&P 100 index is slightly below 29%, the highest level since 2000 and well above the long-term average of 23%.

Source: Bloomberg, 1/31/2012

What’s more, as of the end of January, the largest companies were on average 20% more profitable than the broader US equity market. While large companies are typically more profitable, the current gap in profitability is particularly large and suggests that mega-cap valuations look even more compelling when you adjust for ROE. (potential iShares solutions: OEF, IOO, IDV and HDV).

Source: Bloomberg

Past performance does not guarantee future results.

Disclosure: Author is long IOO.

Tags: Absolute Basis, Amp, Cap Stocks, Caps, Current, Disclosure, Economic Environment, Gap, Idv, Mega Cap, Profitability, Profits, Return On Equity, Roe, Valuations
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Canadian Pacific (CP) – Bill Ackman’s Proxy Fight Presentation

Friday, February 10th, 2012

Activist hedgie Bill Ackman gave his February 6, 2012 Canadian Pacific proxy fight presentation, in which he details his case for a change of management which would unlock value at Canada’s second largest railroad. Its a fascinating look inside the thinking process of one of this generation’s most successful activist investors.

There is also a historical look at Ackman’s past successes to serve as an indication of what is possible for the Canadian railroad, whose shares have traded at valuations well below its North American peers.

At the heart of his proxy fight, Ackman contends that Fred Green, current CEO is one reason the company has underperformed, and that Hunter Harrison, his nominee, would be a more suitable CEO, in leading a transformation of Canadian Pacific.

Among the factual arguments is this nugget:

“Canadian Pacific is 70% the size of Canadian National, yet has an enterprise value 40% as large, due to its inferior profitability and asset utilization.”

Here in the slidedeck below is the complete presentation – fullscreen it for the better read, or download:

Pershing Square – 2012-02-06 – CP

Tags: Activist, Asset Utilization, Bill Ackman, Canada Railroad, Canadian Railroad, Ceo, Enterprise Value, Generations, Heart, Hunter Harrison, Investors, Nugget, Peers, Pershing Square, Presentation, Profitability, Proxy Fight, Shares, Successes, Transformation, Valuations
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Where to Find Value in Emerging Asia

Tuesday, February 7th, 2012

This week, I’m updating my views on some of the emerging market countries in Asia.

While I’m upgrading Chinese equities from neutral to overweight, I’m downgrading South Korean and Indian stocks from neutral to underweight.

Starting with China and South Korea – the two countries are both highly exposed to global growth, but China currently appears to be the better positioned of the two and is likely to hold up much better from a growth perspective.

First, while Chinese equities have performed well year to date, they are down over the past 12 months. As a result, Chinese equities are cheap compared to other Asian emerging market countries, trading at 1.6x book value.

Recent economic data also suggests that growth in China is stabilizing and supports a soft landing. The most recent purchasing managers index, a key measure of manufacturing activity, came out last week at a better-than-expected 50.5, and retail sales growth is actually up to 18.1% year over year. Finally, Chinese inflation, which we all know was a big problem in 2011, is falling. It’s down to 4.1% from 5.5% in November and 6.5% in August.

To be sure, South Korean equities are also cheap compared to other emerging markets. This, however, is normal. South Korea typically commands a big discount due to ongoing uncertainty over North Korea. The cheapness of South Korean stocks is also justified given the country’s worsening economic outlook. South Korea’s economic readings have particularly suffered recently.

Finally, I’m downgrading India in response to the country’s recent surge in valuations and persistently high inflation. Indian stocks appear expensive once again. They are up more than 20% year to date and are currently trading at 2.6x book value. This compares with the Asian emerging market average of 2.4x book value.

In addition, growth in India is still strongly below trend and while the country’s profitability is respectable, it has been on a downward trend over the last couple of months. Finally, Indian inflation, while down from a couple of months ago, is still in the danger territory at 9.3%. All in all, Indian stocks are simply too expensive given current fundamentals (potential iShares solutions: MCHI, ECNS).

Source: Bloomberg

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Copyright © iShares

Tags: 6x, Countries In Asia, Downward Trend, Economic Data, Economic Outlook, Emerging Asia, Emerging Market Countries, Emerging Markets, Global Growth, Growth Perspective, Indian Stocks, inflation, North Korea, Overweight, Profitability, Purchasing Managers Index, Retail Sales Growth, South Korea, South Korean Stocks, Valuations
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Why do Large Cap Firms Trade at a Discount to Market?

Friday, December 9th, 2011

Aleph Blog outlines why he believes “behemoth” companies (i.e. firms with a market value greater than $100 billion) trade at relatively compressed price to earnings ratios:

For Behemoth companies to achieve large earnings growth, they have to find monster-sized innovations to do so. Those don’t come along too regularly. Even for a company as creative as Apple (or Google), it becomes progressively more difficult to create products that will raise earnings by a high percentage quarter after quarter.
As a result it should not be a surprise that Behemoth stocks trade at discounts to the market when global growth prospects are poor. They have more assets and free cash flow to put to work than is useful in a bad environment. Not every environment offers large opportunities.

The below chart outlines, by sector, the market cap of the current 39 behemoths using data from a follow up post at Aleph Blog (he adds even more granularity in his post).

I would also add that I believe these behemoths trade at an aggregate discount due in part by their composition. Financials (and to a lesser extent energy firms) trade at a large discount due to the damage they inflicted upon themselves and the threat of future regulatory restrictions that may impede profitability, both of which may force them to dilute shareholders as they raise / write-down capital. Technology firms on the other hand are constantly threatened by innovation and becoming irrelevant by the next generation of firms (i.e. what happened to Yahoo via Google), thus earnings become difficult to project past even a few years.

Tags: Behemoth, Behemoths, Chart Outlines, Composition, Earnings Growth, Energy Firms, Free Cash Flow, Global Growth, Google, Growth Prospects, Innovations, Market Cap, Next Generation, Price Earnings, Profitability, Ratios, Regulatory Restrictions, Shareholders, Technology Firms, Yahoo Google
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RBC’s Myles Zyblock: The Profitability Miracle? Main Street is Massively Under-Invested

Thursday, April 28th, 2011

RBC Capital Markets’ Chief Institutional Strategist, Myles Zyblock, discusses his insights on how American companies are sustaining their profitability in the post-financial-crisis era.

Myles Zyblock, Chief Institutional Strategist at RBC Capital Markets, talks to Bloomberg’s Tom Keene and Ken Prewitt on Bloomberg Surveillance.

APRIL 19, 2011

SPEAKERS: TOM KEENE, HOST, BLOOMBERG SURVEILLANCE,

MYLES ZYBLOCK, CHIEF INSTITUTIONAL STRATEGIST, RBC CAPITAL MARKETS

KEN PREWITT, BLOOMBERG NEWS

09:10

TOM KEENE, HOST, BLOOMBERG SURVEILLANCE: Now joining us Myles Zyblock, RBC Capital Markets. He’s the 75th equity strategist for RBC. Good morning, sir.

MYLES ZYBLOCK, CHIEF INSTITUTIONAL STRATEGIST, RBC CAPITAL MARKETS: Good morning, Tom. How are you doing?

KEENE: Very good. In there and bouncing off of Alan Blinder’s Wall Street Journal article today, the secretary talked and alluded to a guilded age of income distribution. This equity market recovery we’ve seen, does it talk about markets that are separate of the haves and the have nots? Do we have another guilded age upon us?

ZYBLOCK: You know, my sense here is if you just look at the survey of consumer finances out of the Federal Reserve itself, the ownership of equities obviously concentrated in the hands of the upper income distribution. So as we know, a near 100 percent rally in the stock market over the past couple years has definitely benefited some of the upper income class more so than the rest.

KEN PREWITT, BLOOMBERG NEWS: Well, isn’t that pretty much always the case though?

ZYBLOCK: That is indeed. Well, it is always the case to a degree, but I guess, you know, what a labor economist might look at as you said that the income distribution has never been more skewed as it is today. So in relative terms, I guess the benefits at the margin are going to the upper income class. They have always been going there in level terms, but increasingly so.

KEENE: You have an incredibly powerful page, Myles, and it really goes again, not so much a gilded age, but let’s call it an industrial separation. You have the S&P 500 ex the financials. And you have a chart back 30 years of the net margin of the non-banks. I would just simply editorialize I’m observing a miracle here of profitability, aren’t I?

ZYBLOCK: A miracle – I’m not sure about a miracle, but I would say a lot of hard work and restructuring of corporate America through – Tom, I think the trend upwards, the 30 year trend upward the next financial net margins, is a function of a lot of things.

And a couple I could point to is labor cost savings efforts – some of that is good obviously and bad, like off-shoring and the declining unionization rates. And there is also a lot of innovative progress, like better inventory management systems. And I think these have all come together to push that long term trend higher.

PREWITT: Are we pretty much at the end of that cycle though?

ZYBLOCK: I think we are nearer to the end. I wouldn’t say the end, Ken. It’s – you know, can margins make some new highs over the next few quarters? I think so. You know, my sense here is obviously one of the big concerns that analysts are talking about are commodity price pressures or cost inflation through the commodity complex.

And I think that is going to be more a localized problem. What I mean by that is there are some industries or sectors within the market that are more susceptible to rising commodity prices than others. And some of those include the consumer related segments.

But, you know, talking about a broad-based margin compression, when we look back through time, what really drives margins – the primary driver of margins are still labor costs. And that is, you know, as we estimate, labor costs still account for something like 62 percent of the total cost of doing business.

So if you have an acceleration in wage growth on top of an acceleration in payrolls, that is where you usually see – within a quarter or two, that is where you usually see some more noticeable margin compression, not just the isolated stuff I’ve been hinting at. So in my opinion, I think the margin profile can make some modest gains here. But it will – in my sense, it will start to flatten out as we go into 2012.

KEENE: We’re going to come back with Myles Zyblock, RBC Capital Markets, after Secretary Geithner’s speech with our Peter Cook.

09:21

KEENE: We continue with Myles Zyblock, RCB Capital Markets, looking at equity investment, return of the fear trade. One little sentence here, Myles, really gets my attention. Main Street is massively under invested. What is it going to take besides healing to get Main Street back on Wall Street?

ZYBLOCK: Yes, I mean you make a great point, Tom. It is, you know, we have seen negative net flows into the equity market almost unabated. There has been some short periods of reprieve here, but almost unabated since 2008. And this is really – you know, obviously there has been a lot of psychological damage created as a result of too [two] big bear markets and the housing collapse in the last decade.

Tags: Alan Blinder, Bloomberg News, Federal Reserve, Financial Crisis, Good Morning Sir, Guilded Age, Income Distribution, Labor Economist, Myles Zyblock, Nots, Prewitt, Profitability, Rbc Capital Markets, Relative Terms, Stock Market, Strategist, Street Journal Article, Survey Of Consumer Finances, Tom Keene, Wall Street Journal
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Private and Public Sectors – Motivating and Regulating Markets (Mobius)

Saturday, August 21st, 2010

This article is a guest contribution by Mark Mobius, Vice-chairman, Franklin Templeton Investments.

Even though the government and the private sector have different roles in society, I believe both must depend on a capitalist philosophy in order to be successful. When capital is raised, be it from taxes or from the savings of individuals for investment, it must be put to productive use. Simply put, the capital must result in higher productivity, that is, there should be more goods and services produced for less capital. This translates to higher profitability. However, government organizations are often found to be less efficient in making that transformation because there are few incentives to do so. In comparison, the private sector is mostly driven by profit motives and incentives.

I believe having a motivating factor is fundamental for success and can garner remarkable results. In order to create motivation, government organizations could implement incentives for good performance. This could result in generating higher productivity among government workers, and in turn, they may be able to put capital, in the form of taxes, to better use. We have already seen some governments around the world privatize firms, implementing profit incentives within those organizations, often with stellar results.

I think it is a mistake to speak of free-market capitalism or government-led industry in isolation. The two can and do co-exist, as in countries like China, Russia and India, where the government occupies the “commanding heights” of various industries while applying free-market style incentives to the management levels of these organizations. Labeling a country as following only one of these economic models is often inaccurate at best and detrimental at worst.

Instead, I see the government’s role as an “umpire” in society, mediating between groups with different interests. In order for society to function effectively, opposing forces must be regulated to obey rules and act collectively for the common good. The recent financial crisis was an example of the consequences when governments do not play their umpire role effectively. I believe that the regulatory authorities, the courts and the government departments tasked to regulate the financial industry, for instance, did not adequately enforce rules and work cohesively. They allowed themselves to be influenced by a few key players. This problem was not exclusive to countries practicing free market capitalism—China too, had similar problems—but China’s centralized single-party government was able to move swiftly to correct regulatory errors and thus able to achieve quick results.

The key is to have a government that acts as a true umpire, treating each player fairly and applying the rules equally for all and independent of corrupting external influences. A free market model with an ineffective umpire, inadequate regulation and an uneven playing field is likely no better than a government-led model with no real capitalist system of incentives to maximize productivity.

Copyright (c) Franklin Templeton

Tags: China, China Russia, Commanding Heights, Economic Models, Franklin Templeton Investments, Free Market Capitalism, Government Organizations, Government Workers, Governments, India, Isolation, Management Levels, Mark Mobius, Motivation, Opposing Forces, Private Sector, Productivity, Profit Incentives, Profit Motives, Profitability, Public Sectors, Remarkable Results, Russia, Stellar Results, Umpire, Vice Chairman
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Hugh Hendry: China Infatuation is Misguided

Friday, February 12th, 2010

Hugh Hendry, CIO, Eclectica Asset Management, writes in the Telegraph UK today, cautioning investors that China’s $1.4 trillion credit expansion and $586-billion domestic spend is a white elephant bet on a global recovery in consumption of its exports that remains to be seen.

“In China, investment spending has tripled since 2001 and the consequences are staggering. A country that represents just 7pc of global GDP is now responsible for 30pc of global aluminum consumption, 47pc of global steel consumption and 40pc of global copper consumption. The overriding problem is that the Chinese model leads to a deflationary spiral that is perpetual in nature. Domestic consumption never grows fast enough to absorb the supply, prompting the planners to commit to ever-higher levels of investment. Over-capacity inevitably plagues many sectors of the economy and Chinese profitability is already low.”

Read the whole article here.

Tags: Aluminum, Bet, China, China Investment, Chinese Model, Consequences, Copper Consumption, Credit Expansion, Deflationary Spiral, Domestic Consumption, Eclectica Asset Management, Elephant, Emerging Markets, GDP, Global Gdp, Global Recovery, Global Steel, Hugh Hendry, Infatuation, Investors, Planners, Profitability, Sectors Of The Economy, Steel Consumption, Telegraph Uk, Trillion, White Elephant
Posted in Canadian Market, China, Markets | Comments Off