The Current Risk of Utility Stock Investing

I have a special fondness for York Water (YORW) stock because it has been paying out dividends uninterrupted since 1916. If you can keep sending cash to your owners during General Sherman’s March to the Sea, the Battle of Somme, the Battle of Guadalcanal, and all through to the post-war tech revolution, you deserve commendation for exceeding expectations that are nearly unmatched in the field of business.

But just because I love a corporation’s history does not mean that I can ignore the role price plays in determining whether or not a stock is a good investment at a particular point in time.

When you look at York Water, you should see a business that grows earnings 4-6% over the long haul and raises the dividend by 3-5% each year. It’s basically a glorified inflation hedge that gives you a slight bit of value created in excess of the inflation rate each year.

There is nothing wrong with that. A retiree sitting on 100,000 shares of York Water is going to be able to play all the shuffleboard he wants as he collects his $63,000 in York Water dividend checks each year.

But if you are someone who is trying to build meaningful wealth, rather than inventory accumulated capital from your labor by turning it into a reliable income stream, then you must be especially attuned to the perils of overpaying for any business that only promises the likelihood of slow to moderate earnings growth.

In the case of York Water, the stock traded in the teens ($10-$19.99) at some point during every year between 2001 and 2015. This tight range is not surprising when you encounter a business growing at a low single digit rate.

What is surprising is the the absolute tear that York Water has been on this year. At the time of my writing, York Water (YORW) trades at $36.30 per share. That is crazy. This is a valuation completely disconnected from reality. This is a price so extreme that future shareholders will suffer poor returns even as the business continues to grow earnings.

It will be perplexing to some to watch the business report “record earnings” each year while the stock price languishes. They will wonder what conspiracy is afoot. But there won’t be a storyline interesting enough to break out the soda and popcorn. It’s just the age old tale of Mr. Market’s fluctuation between paranoia and greed as we live through a period in which investors value stable income streams at ludicrous prices.

The $36.30 stock price is in relation to $0.97 in profits. That’s a P/E ratio of 37. You cannot pay that kind of valuation for low to mid single digit growth. The average P/E ratio for this stock is the 15-20x earnings range, and I would argue it ought to trade in the 15-17x earnings range because it carries $85 million in debt against $12 million in profit.

But let’s be slightly optimistic and assume that you get 6% earnings growth from York Water and a terminal valuation of 20x earnings over the next five years. That means York Water will be earning $1.30 at the end of 2021. If it is valued at 20x earnings, what does that give you? A stock price of $26 per share right now. In other words, if things go slightly well for York Water, the stock price will be $10 per share lower five years from now than it is today.

The dividend yield is only 1.7%, so that’s not going to bail you out much when you have $10 per share that you stand to lose.

My guess is that it will take seven to ten years for York Water to be worth the price it is trading at today. In hindsight, the current valuation of York Water will be one of those zags upward on a stock chart that you will look at years later and wonder what people were thinking in 2016.

This is an egregious example, but there are plenty of utility stocks trading at P/E ratios that are noticeably above their ten-year average. This represents a heightened risk because the growth is not going to be high enough to cover up part of the mistake. The fundamentals of York Water, both now and historically, have been admirable. But the current price of the stock has become so extreme that any positive insight about York Water is rendered inactionable due to present overvaluation.

Originally posted 2016-12-03 10:20:26.

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