The best stocks to retire on are those with a highly defensive business model, record of paying out profits to investors and attractive valuations. Unfortunately, stocks that meet this criteria are few and far between because the second a highly defensive equity falls to an attractive valuation, it is quickly snapped up.
However, recent rhetoric from the government regarding the utility sector has weighed heavily on traditional defensive equities such as Centrica (LSE: CNA) and SSE (LSE: SSE) and this has opened up a great opportunity for defensive income investors.
Income opportunity
Utility giants Centrica and SSE are relatively boring businesses. As they operate in a highly regulated industry, earnings growth is essentially controlled by how much they are allowed to increase prices to customers. And with speculation growing that the government may look to introduce pricing caps on utility contracts, investors have fled these two, believing that already sluggish earnings growth is about to go into reverse.
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This selling has sent valuations down to a level where it looks as if there’s already plenty of bad news baked into the price. For example, at the time of writing shares in SSE trade at a forward P/E of 12.6 and support a dividend yield of 6.5%, which is nearly double the FTSE 100 average. Even if government regulation forced the company to cut its dividend payout by 20%, the shares would still yield around 5% at current prices, which remains well above the FTSE 100 average.
So, if the government does decide to act the company remains attractive even considering a dividend cut. If the government doesn’t act, then you’re getting a high-yield, defensive stock for a lowly multiple of 12.6 times forward earnings.
Asset light
Centrica has been forced to rebase its dividend once in the past five years and after this cut, it seems management is more committed to the new, lower payout. Since the last dividend cut the business has also been going through a period of transition, moving away from being a capital-intensive utility towards an asset light supply business. These actions should ensure the group’s earnings are more stable going forward and the changes have also reportedly attracted bid interest from overseas buyers.
As of yet, there’s been no formal takeover announcement, but as one of the UK’s largest energy suppliers, Centrica does look to be an appealing target.
Dividend safety
Once again, thanks to concerns about government intervention in the energy market, shares in Centrica have plunged over the past six months and now trade at a forward P/E of 12.6. At the same time the company’s dividend yield has spiked to 6.1% and the payout is covered 1.4 times by earnings per share.
Using the same dividend stress test at SSE, if government changes were to force Centrica to cut its dividend by 20%, the shares would still yield around 4.8% at current prices, around 1.2% above the FTSE 100 average. And if no further regulatory changes materialise, renewed confidence among income investors should see the shares trend gradually higher.
