Best in breed: Scott Phillips
Cracks are appearing in the image of “bulletproof” stocks
In pre-Covid times, nothing was considered safer than so-called utility stocks. Once the province of telecommunications, electricity and water – services we can’t easily do without – these companies were the “widows and orphans” stocks: businesses whose share certificates could be left in the bottom drawer in full expectation of conservative balance sheets and regular dividends.
In the meantime, the sector has grown meaningfully, thanks to privatisation, the concept of public-private partnerships (PPPs), and the aggressive uptake of financial engineering. Gas pipelines, toll roads and airports, among others, have swelled the ranks of the previously slow, staid and boring utilities sector.
But two things have happened since those days. The obvious one is Covid-19, in particular decimating air travel, and curtailing the number of people using toll roads. To wit: in two short days in early August, Sydney Airport asked investors for $2 billion and Transurban, the largest tollroad operator in the country, reported a loss – the sort of outcome that would have been unimaginable only 12 months ago.
The second is that financial engineering – the creator of so many fortunes – has become a millstone around these companies’ necks. When the structures were devised, the spreadsheet jockeys saw stable, predictable businesses with strong cash flows that could be saddled with so much debt it would make your eyes water … then twice as much again.
So aggressive was the leverage, Sydney Airport, for example, paid out $2.76 a share in distributions over a decade, despite handing down only $1.06 a share in earnings. And that was before the pandemic. On paper it was perfect. But as baseball catcher Yogi Berra is claimed to have said, “In theory, there is no difference between theory and practice. In practice there is.”
The result: previously “rock solid” businesses suddenly look paper thin. There’s little doubt the underlying assets will survive and bounce back, but – like banks taking too much risk before the GFC
– conservative management gets lapped by the “innovators” until the music stops.
The assets are the tortoise, but the structures, unfortunately, are the hare. And shareholders are paying the price. At the very least, they’re not (and arguably haven’t been for years) the safe, stable income plays they’ve been painted as. I highlighted the risk of too much debt in last year’s Best in Breed article on this sector, but I certainly didn’t foresee this pandemic or the impact it would have on otherwise seemingly bulletproof businesses.
And that’s important, because the “why” of buying shares in utilities companies has hopefully changed, for good. You shouldn’t be buying them because they offer dependable income with a reasonably defensive business model.