The out-performance of European utility stocks looks set to fade as investors baulk at expensive valuations and seek out stocks with better growth prospects on hopes the global economy is gathering steam. The DJ Stoxx utilities sector is the best performing sector in Europe this year, its 19-percent rise outshining a 7-percent gain in the broad Stoxx 600 Index.
But since peaking at the start of November, the utilities group has fallen about 2.5 percent, under-performing a 3 percent gain in the Stoxx 600 so far this month.
"We're still overweight utilities but we're beginning to wonder if they have gone up far enough," said Andrea Williams, a fund manager at Royal London Asset Management.
"Some are now looking quite expensive and within that semi-defensive area, we'd probably prefer telecom stocks which have a good dividend yield and at least you've got a bit of growth."
Utilities such as power and water companies tend to trade at lower valuations to higher growth sectors such as technology or media, reflecting steady but unspectacular earnings prospects.
Those defensive characteristics have served investors well in 2004 as concerns about global growth kept a lid on the broader market for much of the middle of the year.
And unlike many sectors, utilities have been able to successfully pass on higher energy costs to their customers.
But analysts estimate that utilities are about 20 percent more expensive than their long-run averages.
They are trading at a price to earnings ratio of around 14 times estimated 2005 earnings, compared with a historical norm of around 10-11 times prospective earnings and around 16 times for the broader FTSEurofirst 300.
"I think we're going to see rotation back into sectors like industrials, some consumer goods companies and certainly materials," said Anais Faraj, a strategist at Nomura.
"On the back of that rotation back to pro-growth and as risk aversion goes down, this sector is going to get de-rated again."
Credit Suisse First Boston reduced its weighting on utilities on Thursday, saying the sector had become expensive and returns seemed unsustainable.
Goldman Sachs cut its view on European utilities to "cautious" from "neutral" on Wednesday, highlighting the risk of rising bond yields acting as a negative catalyst on the sector.
Utilities have higher debt levels than most other sectors, supported by their steady cashflows, but making them more vulnerable to rising interest rates.
The outlook is not uniformly bleak however. CSFB recommends buying back into the sector ahead of a fall in bond yields, a rise in energy prices or given more reasonable valuations.
And some European firms offer interesting prospects, according to Nomura's Faraj.
"Probably 80 percent of the utilities sector is vastly over-valued at the moment, but there is about 20 percent that is interesting," he said, highlighting companies with exposure to big infrastructure demands in emerging markets such as Eastern Europe or China, and non-traditional energy sources.
"Alternative energy is the main theme for that sector, that's where you want to be."
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