Sector Screener: a stock with more than just defensive appeal

Ongoing economic uncertainty may naturally prompt some investors to consider defensive stocks. After all, inflation is proving to be stickier than anticipated across developing economies. This could mean that further interest rate cuts are implemented at a slower pace than previously expected, thereby prompting a downgrade to the global economy’s future growth prospects.

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In addition, geopolitical risks remain heightened. Alongside conflict in Ukraine and the Middle East, the implementation of tariffs by the new US administration, and the potential for an escalation of protectionist policies, could have a detrimental impact on the outlook for cyclical companies. And while such firms may still generate strong returns in the long run, some investors may decide that exposure to defensive shares is becoming an increasingly worthwhile option.

Undervalued opportunities

The Gas, Water and Multi-Utilities sector has historically contained relatively defensive firms. Given that demand for their services is not materially influenced by the economy’s performance, they could deliver a relatively consistent performance over the coming years.

The sector’s recent returns, meanwhile, mean that it may be possible to unearth undervalued opportunities relative to the wider index. While the FTSE 350 index has gained 16% over the past year, the Gas, Water and Multi-Utilities sector has posted a meagre 1% return.

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Although the inherent growth outlook of the sector may fail to rival that of cyclical firms over the long run, given the typically consistent demand profile of utilities, the prospect of upward reratings to the market valuations of its members may nevertheless lead to attractive returns. In addition, the income prospects for the sector have historically been highly appealing and could mean that, on a total return basis, their performance compares favourably with other FTSE 350 sectors.

Source ShareScope. Data as at 18 February 2025. Past performance is not a guide to future performance.

Source ShareScope. Data as at 18 February 2025. Past performance is not a guide to future performance.

Income potential

Indeed, the relative income appeal of the sector may increase over the coming years, thereby leading to higher demand among investors. Although inflation remains above target and is now expected to increase to 3.7% later this year, according to the Bank of England’s forecasts, the central bank anticipates that it will then gradually fall to 2% by the end of 2027. This should provide scope for further monetary policy easing in the meantime, thereby reducing the income return on cash and lowering the yields available on fixed-income securities.

This could mean that the relatively high dividend yields currently available within the Gas, Water and Multi-Utilities sector become increasingly attractive to income-seeking investors. In turn, this may boost demand for the sector’s members, especially since a number of them are aiming to raise dividends by at least as much as inflation over the medium term, thereby having a positive impact on their market valuations.

Debt considerations

Clearly, a period of above-target inflation and restrictive monetary policy has caused a degree of concern among investors regarding the typically elevated debt levels of firms in the sector. In some cases, the interest rate paid on their debt is linked to inflation, while for others it is floating and therefore impacted by interest rates. And even if the interest rate on debt among sector incumbents is fixed, refinancing borrowings at a time when interest rates are 400 basis points higher than they were three years ago could equate to materially higher debt servicing costs.

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However, with interest rates set to fall over the coming years, and inflation expected to do likewise, Gas, Water and Multi-Utilities sector members may benefit from lower debt servicing costs. Moreover, their defensive business models and relatively consistent financial performance mean that, typically, they are able to carry greater leverage than their more cyclical peers without experiencing financial difficulty.

Risk/reward opportunity

Of course, regulatory risks are omnipresent across the sector. New regulatory periods could affect the financial prospects of sector incumbents and may even lead to changes in dividend policies, for example. And with political risk towards some companies within the sector being high at present, share prices could prove to be more volatile than they have been in the recent past.

But with relatively attractive income potential, defensive appeal and, in some cases, the prospect of upward reratings following disappointing share price performances, the sector appears to offer an upbeat risk/reward opportunity.

Source ShareScope. Data as at 18 February 2025. Past performance is not a guide to future performance.

Total return potential

Within the Gas, Water and Multi-Utilities sector, National Grid (LSE:NG.) could offer long-term investment appeal. The company’s shares have risen by just under 3% over the past year, thereby underperforming the FTSE 350 index by 13 percentage points. They now trade on a price/earnings (PE) ratio of 13.5, which suggests they offer fair value for money at a time when the FTSE 100 trades close to a record high.

The stock’s dividend yield is relatively attractive. While the FTSE 350 index has an income return of 3.4% at present, the company’s yield stands at roughly 4.9%. Although this is currently highly appealing relative to other mainstream income-producing assets, and provides a significant boost to the stock’s total return prospects, it is likely to become increasingly attractive amid further monetary policy easing.

Additionally, National Grid is aiming to increase its dividends per share at the same pace as the Consumer Prices Index including owner-occupiers’ housing costs. This should further enhance its income appeal amid a period of sticky inflation and could have a positive impact on its share price due to higher investor demand.

Long-term growth prospects

While National Grid’s business model is defensive, in terms of it being less impacted by the economy’s performance than many other FTSE 350 index members, the company also offers long-term growth potential. It has gradually sought to reposition its asset base away from gas and towards electricity, with the latter widely expected to experience rising demand as the UK persists with its net-zero policy. Indeed, the firm expects electricity assets to account for around 80% of its total assets by 2029. This compares with a figure of 60% in 2021.

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In the four years to 2029, the company anticipates that its earnings per share will rise by 6-8% per annum. This is set to be generated via an ambitious investment programme that the firm expects to total around £60 billion during the four-year period. And with the company’s regulatory gearing expected to remain below 70% over the coming years, it appears to have a solid financial position through which to invest for long-term growth.

Investment appeal

Clearly, National Grid’s shares could continue to lag the wider stock market should falling inflation and interest-rate cuts prompt improved financial performance among cyclical firms. And over the long run, investors who purchase high-quality cyclical stocks when they offer a wide margin of safety may generate higher returns as the economy’s performance ultimately improves.

But the company’s defensive characteristics mean that it has investment appeal during what remains an uncertain period for the global economy. Moreover, its generous income return and fair market valuation, alongside its upbeat earnings growth prospects, mean that it is well placed to generate solid total returns in the coming years. As such, it appears to offer a favourable risk/reward opportunity on a long-term view.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.