It takes a lot to move City analysts to issue ‘sell’ and ‘strong sell’ recommendations on a FTSE 100 stalwart and they rarely seem to do it, opting for ‘hold’ instead.
However, several institutions have recently slapped sell recs on SSE (LSE: SSE) and National Grid (LSE: NG), two of the Footsie’s big-dividend-paying defensives operating in the energy sector. I think it’s worth digging deeper.
Investors tend to seek sanctuary in firms with defensive characteristics when economic times are uncertain. Since the credit crunch almost a decade ago, uncertainty is one thing that has been in plentiful supply.
Perhaps we shouldn’t be surprised to see that SSE and National Grid have been popular on the stock market. These two firms have been riding high with full-looking valuations for a long time, but the valuations of defensive companies can move in a cycle. I reckon a change of investor sentiment could be on the way, which could lead to a valuation down-leg.
If that happens, investors’ capital losses from declining share prices could more than overwhelm any income gains, even if the firms don’t cut their dividends. But what could cause investors to turn their backs on stalwart dividend payers such as SSE and National Grid?
Intensifying political and regulatory scrutiny
Judging by the recent Conservative and Labour election manifestos, the utility sector looks set for intensifying regulatory scrutiny in the years to come. The current popular and political mood suggests that ministers may bear down on energy companies forcing them to cap energy prices for consumers.
I reckon there’s potential for the industry to be shaken up beyond mere price capping. Perhaps legislation will force utility companies to simplify their tariffs and to automatically put all customers on their lowest rate without the need to apply for a new contract every year or so.
Changes like that could squeeze free cash flow in the energy industry making it harder for SSE and National Grid to pay dividends to shareholders.
High debts and high risk
Transmitting and distributing electrical energy and gas is a capital-intensive pursuit requiring vast amounts of money to install, improve and maintain systems. Because of that, both firms have high borrowings, which means investor dividends must compete for the companies’ incoming cash with huge interest payments. If the amount of spare cash declines for these firms (because of increasing regulatory demands regarding capital investment into infrastructure and tighter customer pricing), dividends will need to absorb the shock. There isn’t much room for manoeuvre because forward earnings cover National Grid’s dividend payout just 1.4 times and SSE’s 1.25 times.
It seems clear that National Grid’s and SSE’s share prices would plunge if their dividends are trimmed, potentially delivering investors the double whammy of a loss of capital and a reduced income. To me, the risk seems intensified by the elevated valuations we see in the utility sector.
Could a dividend cut really happen with such traditionally defensive and steady firms like these two? Yes it could. When it comes to change in the industry, a dividend cut is small fry compared to the potential consequences of Labour’s goal to nationalise such firms.
That’s why I’d avoid SSE and National Grid now and think hard about selling if these two were in my portfolio.
Protecting the downside
If you are aiming for financial independence or a wealthy retirement with investing, perhaps guarding against potential drawdowns in your portfolio is the most important work you can do.
I’m wary of National Grid and SSE right now but recommend the Motley Fool analysts’ new report called The Foolish Guide To Financial Independence, which signposts other ways to make your investments work hard.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.