As we head into the final month of 2015, I often find myself reflecting on the year and more to the point what has worked well (as well as what could have worked better).
One of the things that has resulted in me outperforming the market this year (to date, while touching a large chunk of wood!) is the fact that I have been lucky enough to have total lack of exposure to either the mining or the oil & gas sector – two of the worst performing sectors so far in 2015.
And while I do not have access to a crystal ball, I can’t see the chart below getting any rosier for companies such as Rio Tinto (LSE: RIO) and Glencore LSE: GLEN) – at least in the near term.
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Indeed, if I was unfortunate enough to hold either of these shares, then I would be inclined to swap them for a more defensive share such as Severn Trent (LSE: SVT) or Pennon (LSE: PNN) whilst waiting to see how the more cyclical miners fare in these difficult times, where commodity prices remain depressed and the outlook uncertain.
Digging deep in difficult times
Just to make things clear, I don’t think that either of the miners that I’m running the rule over today are likely to go out of business any time soon. I do, however, have some near- and medium-term concerns.
Firstly, one thing that I have learned from experience is the fact that earnings downgrades can usually mean downward pressure on the share price of a company. Additionally, it is often the case that analysts underestimate the speed of the decline, thus causing them to revise down their earnings targets following a negative earnings surprise. While this can work in favour of investors opening a position at the height of the negativity, it is pretty painful for those who hold the shares in the hope that things are going to improve.
In the case of Glencore, earnings per share estimates have fallen from $0.44 in November 2014 down to just $0.10 currently. Rio Tinto has fared slightly better with earnings per share expected to fall from $4.63 to $2.59, according to data from Stockopedia.
Secondly, the debt pile. Now, to be fair, both management teams have set about cutting costs and addressing the debt. This is my main concern with Glencore, which has an enterprise value of nearly 4 times its market cap!
Defensive water and waste
While still on the subject of debt, both of the utilities under review today also have their fair share, too. However, the income here is covered in the main by regulation, not exposed to a fluctuating commodity price. In effect, management are told by the regulator what they can charge customers, and it is down to them to invest in the infrastructure and manage the debt pile as efficiently as possible. If they do this well then shareholders can expect low single digit earnings per share and dividend growth over the long term. Do it badly, however and the opposite is true.
It appears to me that both management teams are pushing the businesses in the correct direction. It seems that the analysts agree with me where Severn Trent is concerned, with earnings per share estimates rising from around 76p this time last year to almost 95p currently. In the case of Pennon, I’d expect to see estimates rise following its interim results released last Friday, which sent the shares up nearly 6% on the day.
It isn’t just me that thinks that the shares are defensive, sadly; the market knows this, and both trade around 24 times expected forward earnings (on a 12-month rolling basis), which isn’t cheap by any stretch of the imagination. That said, the shares still yield nearly 4% — this is expected to grow over time by the retail prices index by Severn Trent and by RPI +4% for Pennon shareholders.
Final Foolish thought
For me, the decision is fairly straightforward: do I want to invest in businesses at the mercy of commodity prices, which are already depressed? Any further weakness here could make it difficult for management to service the debt load and the dividend. Or do I prefer a nice boring business with admittedly less potential for upside capital gains in the good times, but able to pay a steadily rising RPI-linked dividend to me twice a year?
