It pays to be picky, even with defensive trades

WITH markets forecast to slow in the next six months, traders are eyeing traditional defensive stocks as an alternative to other low-risk assets. Government bond yields are now at historic lows, prompting many investors to turn to higher-dividend-yielding utilities shares – but it pays to be fussy, even in a supposedly “safe” asset class.

At a time when investment returns across sectors and asset classes are becoming increasingly correlated with one another, contracts for difference (CFD) traders might be tempted to simply go long on utilities stocks just for the dividend yield. But, as RBS pointed out in a note to investors last week, correlation within the sector is actually relatively low – although it has increased over the last year.

This means that traders have to stock-pick carefully. With tariff and regulatory reviews in France, Germany, Spain and the UK due near the end of 2010, it is vital to keep an eye on political news. Utilities pricing is highly regulated because of the industry’s potential for monopoly control of services like water and electricity supply.

Recent changes have made German power firm E.ON and the UK’s Severn Trent Water highly favoured stocks among analysts. E.ON is recommended in part due to the resolution of some uncertainty surrounding German nuclear power. The government has announced that it will allow companies to extend the lifetime of the country’s stock of nuclear power plants by an average of 12 years and its nuclear tax requirements have proved less bad than expected. Analysts at Deutsche Bank suggest that the news has yet to filter through: “With the market still pricing close to a worst-case scenario, we believe that the downside seems largely protected, and retain our positive stance,” they wrote.

Severn Trent Water, meanwhile, has locked in its costs for the next three years and looks set to benefit from a high retail price index (RPI). RPI drives water prices in the UK because of a regulatory link mandated by Ofgem. Severn is one of few water sector stocks to be viewed as undervalued by Evolution Securities (though admittedly only by 3 per cent) and, with an anticipated dividend yield around 4.9 per cent, it could deliver both capital returns and income. Moreover, the firm’s potential to become a takeover target could drive its stock up further (subject to regulatory approval).

On the downside, analysts recommend selling Centrica and Northumbrian Water. Centrica is vulnerable to the coalition government’s promised crackdown on gas prices as well as a likely requirement for increases in private green energy spending with no up-front cost to customers. And despite Northumbrian’s decent dividend policy (RPI plus 3 per cent), Evolution Securities views it as 13 per cent overpriced – too much of a premium for the income. Of course, shorting these stocks could be expensive for CFD traders, who are required to stump up for the dividend payment when betting against a stock.

The wide divergence of valuations and an abundance of regulatory hurdles means that investors need to be cautious when trading utilities. But for those fearful of a significant slowdown, or even a double dip, going long on certain utilities stocks offers a good alternative to bonds.