While the FTSE 100 has gained 4% since the start of the year, a number of stocks typically viewed as ‘defensive’ have slumped. For example, utility companies SSE (LON:SSE) and National Grid (LON:NG.) have both fallen around 15% this year.
Both companies could offer turnaround opportunities – particularly for those investors who believe some valuations in the market are excessive and are therefore seeking cheaper shares. Further, the dividend yields on offer from both stocks could also make them more appealing as inflation edges higher.
SSE and National Grid’s disappointing share price performances may be due to a range of factors, potentially including a return of capital for the latter. However, there appear to be two main reasons for their declining valuations this year.
The first is a focus on cyclical growth stocks by investors. The ‘Trump trade’ has remained popular throughout the course of the year, and this has caused companies which are able to offer above-average earnings growth rates to become more popular. Since the two utility companies lack strong earnings growth, they appear to have been sidelined along with many of their sector peers.
The second reason is the increased risk faced by UK-focused companies, particularly those operating in industries which could realistically be nationalised. Political and economic uncertainty means that the long-term future of both companies is less clear than it was prior to the general election, and also prior to Brexit. Price caps, nationalisation and difficulties ahead for the UK economy mean that the defensive status of SSE and National Grid has been called into question by some investors.
In spite of the less certain outlook vis-a-vis a couple of years ago, both stocks seem to have investment appeal. SSE has a dividend yield of 6.8% and National Grid’s dividend yield is 5%. At a time when inflation is 3% and may not have yet peaked, higher-yielding shares could become more popular. Interest rate rises may be lacking due to the OBR’s downgrade of productivity and GDP growth announced in the recent budget. Therefore, the Bank of England may have less scope to raise interest rates in order to counter rising inflation.
Both dividends appear to be sustainable given medium term forecasts, while a dividend growth rate which is close to inflation may be possible in future years. Alongside P/E ratios of 10.8 and 15.3 for SSE and National Grid respectively, both companies seem to have margins of safety. This suggests that the market may have already factored in the potential risks which face the two companies.
Of course, the mood among investors at the moment is one of optimism. This situation could continue over the short run and it may cause defensive shares such as those in the utilities sector to disappoint. Similarly, if political instability remains high and the chances of a change in government increase, then SSE and National Grid may suffer.
However, with what appear to be solid business models, high yields and relatively low valuations after share price falls, the two stocks seem to be worthwhile recovery prospects for the long term.
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