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Income-seekers warned over utilities' 'horrific' balance sheets
Utility companies are expensive, highly leveraged and too heavily regulated to make a good return on capital, warns RWC Income Opportunities fund manager Ian Lance.
Lance said the utilities sector in particular is riddled with low-quality companies that do not generate cash and therefore borrow money to pay out dividends, which is unsustainable.
Warning over utilities
‘They tend to have horrific balance sheets,’ Lance said. ‘So, with the stampede to income, people only focus on the dividend yield and load up on utilities.’ He added that utilities are expensive, highly leveraged and too heavily regulated to make a good return on capital.
National Grid (NG.L), SSE (SSE.L) and United Utilities (UU.L), for example, have price-to-earnings (P/E) ratios of 13.5 times, 12 times and 15.2 times respectively, and offer dividend yields of 5.7%, 5.9% and 4.5%.
Lance highlighted that other sectors carry significant earnings risk, which can thwart dividend payments.
‘We have no interest in mining companies,’ he said. ‘One year, P/E ratios are quoted a lot but you look at earnings and they are at all-time highs – so a high P/E on a business with high earnings.
‘But we think earnings will come down everywhere – in the US, Europe and the UK.’
According to Lance, expensive defensive stocks are another area of which investors should be wary. ‘Lots of investors are nervous, so go to safe havens such as consumer staple stocks, which typically have price to earnings ratios of 19 times and yields of under 3%,’ he said.
‘That part of the market is quite expensive. The bottom end of the market is cheaper but poor quality and higher risk. Mining stocks and banks are not of interest, what we look for is in between – a thin wedge.’
Coca-Cola, for example, is trading on a P/E of 19 times and yielding less than 3%, Procter & Gamble 17 times, yielding 3.4% and Nestlé at 18 times, 3.5%.
‘We have a strong value bias and refuse to pay for companies for the sake of being fully invested,’ Lance said. ‘Some parts of the market are expensive, so cash is coming in and building up.’
The fund has about 20% in cash, which has been in place for around a year, he said.
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