Should you dump these two utilities ahead of further declines?
After years of market-beating performance, over the last few weeks shares in leading utility providers United Utilities(LSE: UU) and Severn Trent(LSE:SVT) have plunged, wiping out all of their year-to-date gains.
Indeed, since the beginning of October shares in Severn and United have fallen by around 15%, under-performing the FTSE 100 by 13% over the same period.
The question is, what's behind these declines and will they continue?
Severn Trent and United have benefited from the trend to buy so-called "bond proxies" over the past few years, as interest rates on bonds have plunged around the world. Due to their defensive nature, investors have looked to these companies to provide them with a relatively safe steady stream of income that's greater than the rate of return offered by bonds. Hence the nickname "bond proxies."
However, as investors have flocked to utilities like United and Severn Trent, their valuations have risen to nosebleed levels. City analysts have repeatedly warned that the hunt for yield is driving a disconnect between valuations and the underlying fundamentals, but it seems the market has disregarded these warnings.
Fallen out of favour
Now it appears that the market is finally starting to take notice of the City's warnings. Falling bond yields have made bonds more attractive, and talk of fiscal stimulus from government has sent investors charging into cyclical stocks and re-ignited the inflation debate. As a result, it looks as if "bond proxies" have now fallen out of favour with investors.
It's not just utilities that are suffering from this trend -- other companies that are considered to be defensive bond proxies have also been subject to selling over the past few weeks.
For example, shares in Imperial Brands, British American Tobacco, Unilever, and Reckitt Benckiser have lost 11%, 12%, 11.4% and 7.5% respectively since mid-October. Over the same period, the FTSE 100 has lost only 3.6%.
Look to the long-term
Even though defensive equities have fallen out of favour with investors during the past month or so, for the long-term investor these equities remain attractive.
United and Severn Trent are two of the most defensive companies in the UK. Providing water and related services is a specialist job that requires billions in upfront investment. So, it's unlikely these companies will ever face any serious competition. What's more, utility companies can be a great hedge against inflation.
These highly regulated entities can only raise prices in line with inflation, so in an inflationary environment, utilities often do better than peers that have to keep prices under control to retain customers and absorb the cost of inflation by accepting tighter profit margins. United and Severn Trent do not face similar constraints, so they have more flexibility when it comes to profitability and dividend payouts.
The bottom line
Overall, even after recent declines, United and Severn Trent still look attractive. I think that these two companies could be great long-term investments and investors should concentrate on their long-term defensive position rather than short-term price movements.
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Rupert Hargreaves owns shares in Imperial Brands. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Imperial Brands and Reckitt Benckiser. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.