Utilities are often seen as boring investments. They’re never going to be sexy, they’re never going to cure cancer or have their products at the top of a teenager’s Christmas wish list. That may well be true, but value investors have a history of liking boring companies and Scottish and Southern Energy (SSE) has a lot to like.
Value investors prefer boring
A boring company is often a good thing (although of course, boring is a subjective term). It means that even if solid results are produced year after year, the share price won’t go crazy. Since nobody thinks a utility company can produce stellar future growth, they tend to be reasonably valued.
That’s because the only reason to pay a high price for a company is if you think that future earnings are going to be much higher than they are today.
With many companies that may be a plausible – although usually incorrect – assumption. Perhaps earnings have grown by 20% a year for the last three years; or perhaps a new product comes out that takes the world by storm and is a ‘game changer’.
There are all manner of reasons why investors may get excited about a company, but it usually relies on some sort of happy story about the future. With utility companies though, happy stories just don’t happen.
In fact, very little of interest ever happens. There are rarely big earnings surprises to the upside or the downside. The product is always in demand and recessions are almost irrelevant. The years tick by, the dividend grows somewhat and that’s about it.
But don’t be fooled. The lack of an exciting future can mask a great past. Although the returns in any one year may not get headlines, over the long term they can really start to add up.
A clear plan
SSE has a simple purpose – to provide reliable energy to customers and above inflation dividend growth to shareholders. In their annual reports there is a constant focus on above inflation dividend growth. In fact, this goal is so integral to the operation of the company that they do a great job of explaining why a dividend target is important:
“Receiving and reinvesting dividends is the biggest source of an investor’s return over the long term;
Dividends provide income for those investors who do not wish to reinvest them;
Dividend targets provide a transparent means with which to hold management to account;
A long-term commitment to dividend growth demands a disciplined, consistent and long-term approach to operations, investments and acquisitions” – SSE Annual Report 2011
These are all factors that I would agree with and I’m happy to see them in a company’s reports. If I may quote from the latest annual report one more time, the company’s financial principles (which underpin the long term dividend growth strategy) are outlined and again, they are sound and sensible:
“Maintenance of a strong balance sheet, evidenced by commitment to the criteria for a single A credit rating;
Rigorous analysis to ensure investments are well-founded and achieve returns greater than the cost of capital;
Deployment of a selective and disciplined approach to acquisitions, which should enhance earnings per share over the medium and long term;
Use of the economics of purchasing the Company’s own shares in the market as the benchmark against which financial decisions are taken.” – SSE Annual Report 2011
Four drivers of long term equity returns
In case you missed it, my last post was called The Four Drivers of Long Term Equity Returns. The key point was that equity returns can be decomposed into just four major drivers which, in my opinion, is where investors should focus.
1. Value (or valuation mean reversion, to be more precise)
In the past, shares have sometimes been expensive, sometimes cheap and sometimes just about right. By comparing the current price to the long term earnings power of an investment, it’s possible to have a sensible opinion as to where it currently sits in that range.
The key point here is that valuations are generally mean reverting, which means low valuations tend to rise (via a rising price which investors like) and high valuations tend to sink (via a falling price which investors tend not to like so much).
The FTSE 100 in 1999 is an example of a high valuation with low expected future returns and the same index in 2009 shows a low valuation with high expected future returns. The returns since 1999 have been as expected, far below average and only time will tell how things pan out from 2009, but I expect returns over 5, 10 and 20 years to be above average.
Valuation mean reversion is driven primarily by investor sentiment. Rather than any fundamental change in the investment’s earnings power or dividend policy, what actually changes is Mr Market’s opinion of future earnings. He decides that future earnings will be far lower (or higher) than he thought before, and so the value of the investment changes purely on his opinion of the future.
Based on the above thinking, my main measure of value is PE10, which is the current price, divided by the average earnings over the last decade. As some value investors like to say, “price is what you pay, value is what you get”, and in this case P is the price you pay and E10 (an indicator of the long term earnings power of the company) is the value that you get.
I’m trying to beat the FTSE 100, since that’s the zero-effort default option for investing in UK equities. It’s rational then, that I compare all potential investments against the FTSE 100.
In this case, SSE’s current price is 16.5 times the average earnings of the last ten years, i.e. its PE10 is 16.5, which is above the FTSE 100’s value of 14.5.
The reason for this higher valuation is a higher historic growth rate, which I’ll come to in a minute, but certainly it doesn’t look like valuation mean reversion will be a big driver of future returns (although of course you never know).
Let’s move on to income then. If I can’t expect valuation mean reversion to drive returns, perhaps dividends will.
The yield is currently close to 6%, and since SSE is a utility company in a very stable industry, with the central purpose of the company being to pay the dividend, I’d say it’s sustainable. The company has no history of dividend cuts and I don’t expect there to be any cuts in anything approaching a ‘normal’ scenario.
The FTSE 100 is currently yielding something like 3.5%, so here SSE has a clear advantage of 2.5% a year, assuming the dividend can grow in line with the FTSE 100’s dividend growth.
Growth isn’t something that springs to mind with utility companies, but it is an essential part of SSE given that their stated purpose is to provide shareholders with a sustainable dividend growing above RPI. It’s also an essential part of investor returns over the long term so it’s an important consideration.
Given that SSE’s PE10 valuation is somewhat higher than the FTSE 100’s, and the dividend is only 2.5% higher, I would expect to see better long term growth with SSE, otherwise the investment case may not stack up.
And that’s exactly what I see.
Over the last ten years, SSE has grown earnings by about 8% a year, compared with about 7.5% for the FTSE 100. So earnings growth is effectively the same, but revenue growth has been much higher at over 20% a year.
I think long term sales growth is just as important as earnings growth, as the latter can’t exist without the former, so I like to combine long term earnings and revenue growth into a single number which for SSE is just under 15%.
Although I don’t use a specific measure to gauge the inflation resilience of one business against another, it’s worthwhile having a quick think about the impact of inflation on a company or industry. Does the company have any pricing power or are their margins squeezed beyond zero by rising costs?
In the case of energy and gas companies, it does seem that there is some impact from rising wholesale prices of gas and oil, but it doesn’t seem to be a major threat to their long term viability. All the big players seem to be able to raise prices in line with inflation and beyond, much to the rest of society’s annoyance.
Comparing apples, oranges and investments
In order to compare one thing with another, it’s helpful to have a single measure. Many investors use PE to compare investments, and this ratio has been extended in the past to include growth rates (PEG) and dividends (PEGY, where Y stands for yield).
In my case, since I am interested in companies that can sustain profits, growth and dividends over the long term I prefer to use PEGY10, which is the same as PEGY but it uses ten year average earnings and growth rates.
This ratio provides a shortcut to finding investments that may be able to generate good returns through any combination of high value, growth or income.
For the FTSE 100 the numbers are:
PE10 = 14.5 Growth = 7.6 Yield = 3.3 PEGY10 = 1.3
For SSE the numbers are:
PE10 = 16.5 Growth = 14.9 Yield = 5.8, PEGY10 = 0.8
On the basis of a lower PEGY10 score, as well as the fact that Scottish and Southern Energy is a very stable company and relatively low risk, I think it is currently a reasonable investment and perhaps a better investment than a FTSE 100 index tracker.
I have added SSE to the model portfolio at 1,333 pence per share and look forward to above inflation dividend increases for the next few years. Alternatively, if the price goes up too much and the shares become poor value, I’ll sell.