The conventional wisdom is that when interest rates go up, utility stocks go down, but with the Bank of Canada continuing an aggressive tightening campaign – one that is expected to produce a jumbo hike on Wednesday – there’s a twist to the narrative.
Unlike other high-yielding stocks such as telecoms and real estate investment trusts, shares of Canadian utilities have proved surprisingly resilient even though rates are rising. The sector is one of just three in the S&P/TSX Composite Index that is up year-to-date, through Tuesday. Its gain of roughly one-10th a percentage point since Jan. 1 trails only energy, which is up nearly 17 per cent, and consumer staples.
Investor demand for utility stocks remains so strong, despite the rate hikes, that even Hydro One Ltd. H-T, which recently announced it is looking for its second chief executive officer in four years, is on a tear. Ontario’s electricity transmission company has climbed 6 per cent this year while the S&P/TSX is down 12 per cent.
The utilities sector’s strong market performance appears to have given its CEOs licence to proceed apace with growth plans. On Tuesday, TSX-listed Capital Power Corp. CPX-T announced it will partner with Manulife Investment Management MFC-T to buy a Michigan natural-gas facility, for US$373-million plus the assumption of US$521-million of debt from the infrastructure unit of Ontario Municipal Employees Retirement System, which is the seller.
Shares of Alberta-based Capital Power, which were flat on Tuesday, are up 15 per cent year-to-date.
Oddly enough, utilities are benefiting from a gloomy economic outlook.
Typically, as interest rates on safe government debt and less-risky corporate bonds rise, the dividend yields on utility stocks are less enticing to income-oriented investors. But in a recent note to clients, RBC Dominion Securities analysts Maurice Choy and Robert Kwan said recession fears are prompting investors to buy and hold utility stocks despite high valuations in the sector.
“Traditionally, we would have expected investors to monetize their positions and possibly exit the sector in search for better value,” the analysts wrote. This time, though, “investors do not appear to be deterred by the elevated sector valuation.”
In fact, they added, “investors are preparing to increase their positions in regulated utility stocks if indeed a recession is coming.”
Despite the disconnect from continuing rate hikes, there is a historical justification for this. Mr. Choy and Mr. Kwan looked at the combined performance of Fortis Inc. FTS-T, Canadian Utilities Ltd. CU-T and Emera Inc. EMA-T and found the three stocks outperformed the S&P/TSX Composite nine times over the past 10 stock market downturns, by an average of 25 per cent on a price-only basis (that is, before dividends).
And looking back, the analysts found that utility stocks began outperforming the broader index, on average, 12 months prior to the start of the recessions and reached their prerecession highs about six months prior. After recessions started, utilities continued to outperform, reaching a recession high, on average, about four months in.
Investors seek safety from utility stocks because the business models are relatively low-risk, even in the event that energy usage moderates. And while much of the sector is highly regulated, preventing prices from swinging too wildly, a number of utilities have permission to raise prices in inflationary environments.
The analysts estimate Canadian utilities should still be able to grow earnings per share by about 4 per cent to 6 per cent and deliver dividend yields of around 3 per cent to 4.5 per cent, even in a recession.
However, it’s not clear just how much more outperformance is to be had for today’s buyers: According to S&P Global Market Intelligence, Hydro One trades at 21.3 times forward earnings and Fortis trades at 21 times. Emera has a forward P/E of 20, and Canadian Utilities, 17.3. Anything above 15 times is traditionally considered expensive.
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