It may seem silly to suggest that United Utilities (LSE: UU), Severn Trent (LSE: SVT) and Pennon Group (LSE: PNN) are all set to fall next year but there’s plenty of evidence to suggest that this will be the case.
For example, it’s now widely believed the Bank of England and US Federal Reserve will begin to raise interest rates at some point over the next 12 months, which is great news for savers. However, according to financial data company Morningstar, over the past few decades a trend has developed between the share prices of defensive companies and interest rates.
Indeed, it has been found that the shares of defensive companies tend to act like bonds, in other words, share prices rise when rates fall but then prices fall when rates rise.
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For the most part, this trend can be traced to a rush for income. Investors have been buying defensive stocks with attractive dividend yields because they can no longer achieve an attractive rate of interest on their savings. When interest rates rise, investors dump risky stocks in favour of holding cash in the bank.
So, after a five-year-long rally driven by the rush for income, there’s reason to believe that United Utilities, Severn Trent and Pennon Group could fall back to earth as rates rise.
An interest rate hike is not the only reason to believe that these companies will perform poorly during 2015.
Overvalued
Although United Utilities, Severn Trent and Pennon Group are, by their nature, defensive investments; they can still be overvalued and right now, compared to historic figures, that’s exactly what they are.
Take United Utilities, for example. The company currently trades at a forward P/E of 19.5 compared to its 10-year historic average of 14. Furthermore, United’s dividend yield is at a five-year low of 3.9%, compared to the five-year average of 5.2%.
But United looks cheap compared to Pennon Group. Indeed, thanks to bid speculation over the past 12 months, Pennon trades at a significant premium to its sector peers. Specifically, using the enterprise value to earnings before interest tax amortisation and depreciation metric, or EV/EBITDA, Pennon trades at an EV/EBITDA value of 14.8 compared to United’s 11.7 and Severn’s 10.9. That’s a premium of 31%.
Additionally, after rising 37% this year, Pennon’s dividend yield has been depressed to a lowly 3.4%, far below the average FTSE 100 yield of 3.7%. It’s clear that there are better deals to be found elsewhere.
Severn Trent does support the highest dividend yield of the three companies at present levels. The company’s dividend yield currently stands at 4%. However, Severn currently trades at a forward P/E of 21.6, 35% above its five-year average of 16.
Set for a fall
Overall, the evidence suggests that if interest rates being to rise next year, United Utilities, Severn Trent and Pennon Group will fall, as investors move their cash elsewhere. What’s more, United Utilities, Severn Trent and Pennon Group appear to be overvalued when compared to historic valuations and peer averages.
All in all, it might be time to take profits on these companies and seek better opportunities elsewhere.
