Classic widows-and-orphans stocks are gaining renewed respect amid this year's wild stock market swings.
Utility and pipeline companies enjoy stable cash flows from long-term contracts. Many operate in heavily regulated environments that shield them from competition. Even in a slowing economy, they can continue to churn out steady dividends.
"These assets really show their true worth in an environment like we are seeing now where people are concerned about growth," says Jason Gibbs, a manager with Goodman & Co. Investment Counsel Ltd. "It's nice to own something like a regulated utility or pipeline company where you know every single day there are millions and millions of people who have to use your product."
Some of these defensive stocks trade between 14 to 20 times forward earnings and are at the higher end of their historical range. However, they are still "very reasonable," asserts Mr. Gibbs, who runs the Dynamic Global Infrastructure Fund. He notes that many utilities pay dividend yields above government bond yields, and those dividends can grow.
Over the past year, he has moved away from more economically-sensitive companies to focus on income-generating stocks such as pipeline operators Enbridge Inc. and TransCanada Corp. , and U.S.-based electrical transmission provider ITC Holdings Inc.
The biggest risk to utilities and similar stocks is the threat of increased government intervention that can reduce earnings or increase taxes. That is more of a concern in European countries focused on raising taxes to reduce debt, he said. In Britain, which has a friendly regulatory environment, he holds water utility companies including Severn Trent PLC and United Utilities Group PLC.
Other investors are also seeing the merits of putting money into utilities, particularly companies that cater to vital, recession-proof needs such as water. "Numerous water companies are targets of acquisition," said Michael Underhill, who oversees $700-million (U.S.) in infrastructure assets as chief investment officer at U.S.-based Capital Innovations LLC. "You are seeing a trend in which private equity funds as well as infrastructure funds are seeking deals in the marketplace."
He suggested that the premium valuation on stocks of regulated utilities is justified because of their ability to increase earnings even in tough times.
"Not many stocks are showing earnings growth right now," said Mr. Underhill, author of The Handbook of Infrastructure Investing. "Investor demand will keep these stocks up, as a large number of investors who are nearing retirement age are focused on income-generating investments."
Mr. Underhill, who recently began managing the Exemplar Global Listed Infrastructure mutual fund in Canada, is particularly bullish on water and wastewater utilities. He likes American Water Works Co. Inc. and Aqua America Inc. , and also owns shares in electric utilities such as American Electric Power Co. and gas utilities like Sempra Energy . In addition, he is a big fan of pipeline limited partnerships such as Kinder Morgan Energy Partners , Alliance Resource Partners and AmeriGas Partners .
Pierre Lapointe, a global macro strategist at Brockhouse Cooper, said the attraction of defensive stocks is understandable given the darkening outlook for the global economy. "We expect Europe will fall into a recession," while the U.S. economy is stalling, he said.
But he said that traditional defensive sectors are getting pricey so investors should consider other stocks with high dividends, particularly if those companies also have high returns on equity and low debt levels. "We expect higher-dividend paying companies, including utilities, to do well over the next year."