Oct

12

It's generally accepted that large electric utility stocks are interest rate sensitive. They also have earnings growth based on a regulator-sanctioned "acceptable return on capital." The stocks are considered cheap when they are trading near book value (not now), and also when their yields are relatively high versus treasuries and bonds (yes now). There's some economic sensitivity to electric demand of course– but the stocks are still very low beta.

I posit that at their current relative prices, a basket of quality utility stocks should outperform TIPS… with similar risk and reward. The reason is not that utility stocks are particularly cheap, but rather because many TIPS have trivial and/or negative real yields. In a rising inflation environment, utilities should be able to get regulator approval to raise prices [to maintain their statutory ROE]– and in the current status quo environment, the stock yields will exceed the TIP yield.

At this moment, the 5yr Treasury has a 1.1% nominal yield, the 5 year TIP has a -0.50 real yield, and the UTY has a 4.34% nominal yield.

What am I missing here? Other than regulatory risks, in what environment will the UTY significantly underperform a 5-year TIP held to maturity?

Mr Krisrock comments:

In his book on theory, Ray Dalio of Bridgewater theorized that "stress testing" an investment theme by asking other unsuspecting traders their views, in effect is a surreptitious poll, as we note here in this textbook case of pedestrian "street begging".

Rocky Humbert responds:

Perhaps Mr. Krisrock will be so kind as to put a penny in this beggar's cup with an insight using all of his over-sized frontal lobe (and not just the amygdala).

I thank the speclisters who kindly pointed out (offlist):

1) During the 1930's depression, utility stocks held their dividends… And people who paid their bills saw higher rates to compensate for the people who did not pay their bills.

2) The TIPS will return par at maturity — there is no similar guarantee for utility stocks.

3) Because TIPS are currently trading at a premium to par, outright deflation can be injurious to their returns.

4) Utilities are taxed as corporations — and are also subject to the risks of cap&trade etc. However, the state rate-setting boards may/may-not compensate for the increased costs of cap&trade with rate hikes.

The daily and weekly statistical correlations between utes and tips are quite poor. But as the attached chart shows, they do seem to move in the same directions.Perhaps foolishly, I'm least worried about technological innovation– because the primary motivation for investing in a regulated utility is that they set rates based on a statutory ROE….

Jeff Watson writes:

Wireless electrical power transfer has been around since Leyden, Franklin, van de Graaf, and Tesla, just to name a few. Radio waves are a wireless electrical transmission system….just ask me, as a ham radio operator I have gotten many very nasty RF burns when my system wasn't properly grounded, or I stood directly in front of a beam antenna when someone keyed up the transmitter putting 2KW through the antenna. Further back was the study of charged amber by the ancient Greeks and the ability to turn static electrical potential into kinetic energy. The thermoelectric effect has reputedly been described since the middle ages. Now, the newest commercial application of wireless electrical transfer is with those new cellphone and iPod chargers where you just lay them on the pad and it magically charges the batteries with no electrical circuit. One might expect for more practical applications as time goes by and the market demands the convenience.  

Mr. Krisrock adds:

In India, for example, there are many rural areas without electricity or the likelihood of same. Some years ago we partnered with Reliance and built cell towers with solar panels that allowed locals to plug in their mobile phones into the cell towers to recharge them. Until we did this they had to send them back to the cell phone company to recharge them…clearly some pennies for the beggars cup…. 

Tyler Mclellan comments:

You're missing this. The future nominal rates are the sum of the short rates (at least to some point on the yield curve). If you finance the position at overnight money (which many marginal buyers do), you cannot lose money if the sum of the short rates is less than the yield. I repeat, no matter what happens to inflation etc…you cannot lose money so long as the short rates one finances at are less than the yield. Through one more iteration, TIPS work the same way.

So i suspect the answer to your question has to do with the nature of "return".

David Hillman adds:

Once we could not imagine a wheel nor a printing press nor telescopes nor electricity, nor steamships, nor the camera, nor the radio, nor the automobile, nor the incandescent light, nor telephones, nor submarines, nor television, nor computers, nor endoscopic surgery, nor nanotechnology.

The 4 ounce, 4.75"x2.5"x0.5" device clipped to my belt is a GPS, a voice recorder, an 8MP camera, a calendar, an alarm clock/stopwatch, a music/video/tv player, a language translator, a dictionary, an encyclopedia, a library, an internet browser, it allows remotely operating a computer half-way across the globe, it connects to gmail, to WiFi, it recognizes touch commands and voice commands, it will both convert the spoken word to text and vice versa, and oh, yes…..it's a telephone, too. The cost of entry is $99 + $55/mo. Such a device was not imaginable as recently as 20 years ago.

A world without a power grid depends upon a collective will to have it, vision, investment, R&D, innovation, efficient production, practicality, affordability, and profitability.There are many individuals moving "off the grid" now, some adopting current [no pun intended] technology, wind, solar, water, other renewable, that allows same, others eschewing that technology in favor of more basic passive and mechanical means, horsepower and elbow grease.

But while basic technology exists, instead of pursuing advancement in earnest, we persist in taking the easy, short-sighted, petroleum-based way out, screwing ourselves in the process.Still, given the history of technological advancement, one might suggest somewhat optimistically that, someday, we will will it and the question is less "could there be?" than it is "when?" Until then, we'll just plod along from crisis to crisis as we humans are wont to do. Plus ca change….. 

Jeremy Smith comments:

You wrote, "It's generally accepted that large electric utility stocks are interest rate sensitive. They also have earnings growth bas…"

"Generally accepted" is statistically incorrect, at least since 1994, which is a long time. Correlation to bond prices is actually negative. Utility dividends also increase. They can estimate 3-4% increase for an index of these, more for the better companies. Of course the longer you hold a higer yielding stock with dividend growth, the more hopeless fixed income is by comparison, especially with regard to income generated. As income rises it forces higher the value of the instrument producing the income, all other things being equal.

Phil McDonnell comments:

I do not think that it is generally accepted that utilities are negatively correlated with bonds but that appears to be the case. I picked idu for utils, tlt for 20+ treasuries and shy 1 yr treasury. For last 105 days of daily net changes we have the following co-terminal correlations:

idu    tlt idu
tlt    -59
shy - 54 74

Perhaps the utility– interest rate connection is more complicated than upon first reflection. 1. They are heavy borrowers for their capital equipment financing so one would think they are hurt by higher rates. 2. Their are regulated, so when their regulators are convinced that rates have risen they will often give them rate relief which means higher rates are eventually mitigate. 3. The stocks sell in competition for investment dollars with other income producing assets such as bonds etc. So they must be priced to yield competitive returns. 

Steve Ellison writes:

Could it be that there is little interest rate sensitivity when rates are very low? Or that the correlation was arbed away when everybody knew about it? Last year, I noted a similar regime change in the correlation of stock prices and interest rates.

Tyler McLellan writes:

Look, stocks and bonds have been Correlated negatively in price terms since 1999/2000, I would bet that utilities have been correlated enough to the market as a whole that they've been at least partially along for the ride.

One reason to suspect this? Maybe if equity price are set my marginal preferences of equity investors if tech stock a goes down and that makes people want to sell some ute b to buy more, it might not matter that bonds are twenty bps lower, especially when the bond buyers don't care about either.

Rocky Humbert writes:

I played with the data a bit more, and it looks like the Tyler and Steve's observations account for most of the the regime change. The Ute's stock market beta/correlation dwarf their bond market beta/correlation (notwithstanding the low stock mkt beta of Utes.) Since stocks versus bonds have gone their separate ways over the past 12 years– the ute's regime change riddle is mostly solved.

There is one last data point worthy of mention: more than 65% of the UTE's total return is due to their dividends…and the attached chart graphically illustrates investor preference for utility dividends versus bond market dividends. This chart highlights the fact that the mean dividend yield for utes is 69% of the bond yield … and we are currently 3 sigma cheap…on a yield comparison basis. But that's true of many stocks…

My intuition remains that Ute's will probably outperform 5-year TIPS from these relative prices, but it appears that this intuition is a restatement of my bias that stocks overall should outperform bonds from these relative prices. If Ute's get whacked because of a hike in dividend tax rates, this may provide an attractive entry point for Ute's on their own absolute-return merits.

I'd like to thank everyone for contributing their thoughts (especially when they disagree with my thesis). It's a pleasure and privilege to interact with a group of such intelligent, independent-thinking people.

Jim Sogi comments:

Undistributed power using local generation, solar, wind, battery, water will be what undermines the monopoly just as cell phone undermined the phone land grid. 

Stefan Jovanovich replies:

I think it is an exaggeration to argue that the cell phone has "undermined" the phone land grid. The "land" grid is, in fact, the backbone that now connects all the cell towers; if wireless were truly able to handle the data rates, the towers would be off the grid. They are not; and the "wholesale" wireless technology– microwave– has been the greatest single casualty so far during this wireless revolution. 


Comments

Name

Email

Website

Speak your mind

Archives

Resources & Links

Search