Everything in moderation. We believe this phrase applies to the “safety trade” as well. Recently, we have seen many strategists/traders suggesting that they are positioning equity portfolios using a “barbell” approach – pairing aggressive momentum names (including IPOs) with lower-BETA defensive stocks (Utilities, Consumer Staples, REITs) — primarily as a way to deal with market risks with resolutions that are binary in nature (trade war, Fed policy, Brexit, etc.).
The defensive side of this scale is pretty classic, especially when implemented during a period characterized by lower interest rates. When rates move lower, investors typically search for bond substitutes, gravitating towards sectors with historically higher yields. Often, we believe these sectors are also perceived to be less sensitive to the business cycle in a downturn. Utilities and REITs offer the added benefit of being primarily domestically-focused. According to the Bank of America Merrill Lynch, equity fund flows into Utilities, Consumer Staples and REITs have accelerated over the past four weeks.
In our view, Utilities have come too far too fast — in many cases, valuations are now significantly disconnected from underlying fundamentals. As the table below illustrates, P/E ratios have expanded significantly since volatility picked up after the third quarter of 2018.
As of today, the Utilities sector trades at an average Forward P/E ratio of 19.2x vs. 17.9x for the S&P500 – reportedly, a gap that is at the higher end of historical ranges. Relative to its own historical valuation (since 1990), the Utilities sector is trading at 98% of its high Forward P/E of 19.6x and 133% of its average of 14.5x.
The Wall Street Journal suggests that the “poster child for this utility-mania” is American Water (AWK) trading at a 32.2x Forward P/E and a 3.6 Forward PEG. To provide some perspective, tech companies with much higher secular growth rates trade at similar multiples. Admittedly, American Water has an expected growth rate that is well above most of its utility peers (at 9%) and benefits from the water scarcity theme.
If the benefits of perceived safety have already been largely realized prior to a downturn as a way to deal with a raft of binary global macro risks, we think defensives like Utilities may disappoint in an actual recession.
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The views presented herein are those of Validus Growth Investors, LLC and are provided for informational purposes only. The information is current as of July 2019 and is based on the economic and market conditions as of this date. The information is not intended as a discussion of the merits of a particular offering and should not assume that any discussion or information provided herein serves as the receipt of, or as a substitute for personalized investment advice from Validus Growth Investors, LLC or any other investment professional.
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