Shares: Long-term promise in utilities

SHARES in the electricity and water utilities are proving to be among the star turns of the UK stock market in the Nineties. They have done so well that even such long-term bulls as Angelos Anastasiou, an analyst with Panmure Gordon, the stockbroker, are turning cautious and pointing to the regulatory risks that lie ahead. But my hunch is that we are seeing a re-rating of utility shares that could still have some way to go.

Commentators keep telling us that index-linked gilts are attractive on yields of up to 3.5 per cent, with capital protected against inflation. But most investors will conclude that utilities, on prospective yields ranging up to 5.5 per cent, and with income likely to grow by several points more than the rate of inflation, are a far more enticing proposition. The regulatory risk looks well worth taking.

Virtually all the utility privatisations were absurdly underpriced at flotation. The terms reflected a view that water and electricity were extremely boring businesses, and only the prospect of huge starting yields and guaranteed inflation-adjusted dividend growth thereafter would persuade investors to buy them. In addition, the whole sector was new to the UK stock market and there was great uncertainty about just how they should be valued, which made for the initial caution.

Events in the Nineties have brought into sharp focus, however, the attractions of utilities. As businesses, they are extremely solid - most enjoy local monopolies. Returns on competing investments such as cash and gilts have dropped sharply. The dividend growth achieved - often in double figures - also looks attractive when inflation is low and many commercial and industrial companies are struggling to maintain their dividends.

Another positive factor has been a growing confidence among investors that the regulatory environment will strike a reasonable balance between the interests of shareholders and consumers.

In the case of water, for example, Ian Byatt, who is working on the new regulatory environment that will govern water companies after April 1995, has impressed observers as a reasonable and conciliatory figure. Life is expected to become tougher, but not so tough that shareholders cannot enjoy dividends increasing by two or three percentage points more than inflation each year.

The electricity industry companies might seem to be more at risk, with less need to compensate shareholders for the huge water-related capital expenditure programmes. But the underlying logic of the regulatory climate - at least under Tory governments - is that regulation is based on price rather than dividends or profits, leaving companies an incentive to become more efficient by being allowed to pass on some of the benefits to shareholders.

Investors can happily turn to the two sectors in the prices pages of their newspapers marked electricity and water and pick a stock with a pin. The stocks all perform broadly in line in terms of capital and dividend growth, with a comparatively narrow range between the best and worst performers. There does not even seem to be much difference in performance between different types of utility, although there is a case for spreading risk by including in a portfolio, say, one electricity distribution company, a power generating company (PowerGen or National Power) and one or two of the water companies.

Very roughly, starting yields should be around 5 per cent and should grow by around 10 per cent in the future; although PowerGen has excited investors by bringing forward its final dividend to beat the drop in the associated tax credit from 25 to 20 per cent, and improving on expectations by increasing the total payment for the year by 13.5 per cent over the previous year.

Private investors have an intriguing option not open to the big institutions, which is to invest in one of the thinly traded but booming local water supply companies, such as East Surrey at 335p, South Staffordshire at 1,325p or Mid-Kent at 294p. These are much smaller than the 10 privatised water authority groups, and only supply water to fairly small catchment areas. They therefore do not have the expensive obligations of sewage treatment and disposal.

Until the new water industry regulatory climate was introduced in 1989, these companies had to pass on all profits growth in reduced prices to consumers. When that changed, their profits began to soar and dividends are now climbing, typically at around 15 per cent a year. The prospects are good that this will continue at least until the new regime is set up in 1995.

Their shares have been the best-performing utilities of all. With predators hovering and many strategic stakes held to facilitate future deals, the number of these local water companies is steadily shrinking. They may prove the best buys.