The yield curve inverted in August 2019, signaling to many investors that a recession and corresponding equity market pullback were imminent. Historically, there is an 18-month average lag between yield curve inversion and corresponding stock market downturns, but risk-averse market participants may want to consider the merits of increasing exposure to defensive stocks in their equity portfolios.
Defensive stocks, such as utilities companies, experience less deterioration of demand for their products and services during recessions, and they often deliver better-than-average performance in poor market conditions as a result. Utilities companies often pay healthy dividends due to the relative stability of their cash flows and limited growth potential, which is a good way to deliver investment returns in the absence of market appreciation.
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When evaluating a utility stock, there are several key characteristics I want to analyze using financial metrics. Dividend yield has obvious importance, as it represents the return generated for the investor while the downturn is navigated. I also consider the debt-to-equity ratio and net profit margin for two important reasons. First, these provide some insight into the fundamental stability of a company, and it's wise to avoid situations where narrow margins could be squeezed or debt-heavy enterprises experience issues when cash flow is inhibited. Further, these metrics directly impact return on equity (ROE), which is valuable for assessing management quality and capital structure optimization. Finally, valuation multiples, notably price-to-book and enterprise-value-to-EBITDA (EV/EBITDA), can help quantify downside risk if market valuations begin to falter.
1. The Southern Company
The Southern Company (SO 1.15%) is a natural gas power utility that operates in Illinois, Virginia, Tennessee, and Georgia. At $61.11 per share, the stock pays a 4.06% dividend yield, outpacing the sector average of 3.38% by a substantial amount, and a 25-year track record of steady dividend growth. Management is delivering 17.2% ROE, which is 5 percentage points above the sector average, due to both higher than average leverage and profit margins. The price-to-book ratio of 2.37 and EV/EBITDA of 13.5 are both slightly higher than the sector average, which limits the price downside that can be driven by valuation erosion across the market as a whole. In the 2008 downturn, Southern Company shares fell 12%, compared to a 42.3% decline for the S&P 500 between July 2007 and July 2009.
2. The PPL Corporation
The PPL Corporation (PPL 1.29%) operates electric and natural gas utilities in the U.S. and U.K., with substantial concentration in Kentucky, Pennsylvania, and Virginia. Dividends have grown steadily since 2003, and 5.2% is exceptional. A 14.8% ROE on wide profit margins and moderately above-average leverage is encouraging. Price-to-book at 1.91 and EV/EBITDA at 10.6 are also both very enticing. Shares did sink 37% in the 2007-2009 crisis, but this looks like a decent value play with some wonderful dividend income opportunity.
3. NorthWestern Corporation
NorthWestern Corporation (NWE 0.54%) produces and delivers natural gas and electricity for customers in Montana, South Dakota, and Nebraska. Dividends have grown steadily since 2005, and the 3.08% yield today is attractive, given the underlying fundamentals and a dividend payout ratio with room to grow. ROE of 11% is delivered through strong profit margins without excessive leverage. Price-to-book is 1.87 and EV/EBITDA is 13.6, so valuations are very reasonable. NorthWestern shares only fell 25% in the last market crash, so there are several signs that this could be a safe dividend play without any obvious red flags.
Of the three candidates examined here, The PPL Corporation is the most attractive opportunity today. The role of these stocks would be to deliver dividend income and downside cushion in a market downturn, so PPL's dividend yield and modest valuation metrics are very attractive for those purposes.
