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When Hunting Value Stocks,
Seek the Next AES Corp

If these value stocks can avoid the worst-case scenarios that current prices reflect, investors are set up for big gains over the next 6 to 12 months, asserts Income-investing expert Roger Conrad, editor, Conrad’s Utility Investor.

Is the world’s economic cup half empty or full? With the fog of the November election campaign season fully descended, politics is affecting how many are answering that question. But the truth is closer to the opening line of Charles Dickens’ "A Tale of Two Cities" – "It was the best of times, it was the worst of times."

New highs set almost daily by the S&P 500 and Nasdaq 100 are welcome news indeed. But stocks’ performance is far from even, with less than 200 S&P 500 stocks actually ahead of where they closed on February 19 of this year. And 25 percent are underwater by at least 25 percent.

FactSet recently reported 60 percent of index Consumer Staples and Healthcare companies were on higher ground than in February. Only 8 percent of Energy and Utility stocks were.

Retail offers a particularly stark example of divergence within sectors. S&P Global Market Intelligence reports sector bankruptcies at a record 44 year-to-date. But the "Big Six" retailers announced robust Q2 sales, fueled in large part by record online shipping.

The Big Six have adapted to profit from changes in consumer and business spending wrought by Covid-19 fallout. And that’s also been the clear difference maker market-wide for avoiding big hits to earnings, dividend cuts and worse.

With the Northern Hemisphere on the brink of another flu season, stakes for developing effective treatments and vaccines for this pandemic have arguably never been higher. And as every economic opening seems to bring a fresh outbreak, Covid-19 fallout is very much with us now.

That means companies feeling the pain will likely continue to for the rest of 2020. And so will those doing business with them, from banks with weaker borrowers, to landlords with financially-stretched or unemployed tenants and companies heavily dependent on business spending.

That’s food for thought when it comes to continuing underperformance of "value" versus "growth." No stock market rally has endured long without the eventual participation of the slower starters.

Value stocks by definition sell at discounts, be it lower P/Es or higher yields. For some, the reason is sluggish earnings. For others, it’s cyclicality of the core business or sector unpopularity. But to move to a higher level, something has to change to entice investors to pay more.

In most "value" sectors, it’s going to be very difficult to overcome current challenges, so long as the pandemic is affecting health and economic behavior. One place to look where that’s not the case: The nearly 200 essential services companies I track in Conrad’s Utility Investor.

Exhibit A is their strong Q2 results. Electric, natural gas and water companies continue to benefit from regulatory mechanisms, such as revenue "decoupling" from actual usage. Most have also offset reduced demand from commercial and industrial users with cost savings and higher usage from shut-in residential users.

Heavy investment in renewable energy remains a potent source of growth for power companies. That includes, not surprisingly, NextEra Energy (NYSE: NEE), which is expanding both rate-based and contracted wind and solar. But once-scorned "yieldcos" showed strength as well, with new projects entering service on time and budget and fully contracted. Clearway Energy (NYSE: CWEN) boosted its dividend nearly 50 percent, as its biggest customer PG&E Corp (NYSE: PCG) exited bankruptcy and freed up company cash restricted by debt covenants.

The best of the biggest communications companies posted very steady results at their wireless and fiber broadband businesses. Those with large media and entertainment operations like AT&T Inc (NYSE: T) took big hits to sales as movie theaters, live sports, theme parks and advertising all remain impeded to some degree.

But even AT&T was able to take advantage of record low borrowing costs to slash interest costs and refinancing risks, issuing $17 billion of new bonds during the quarter. That lowered the company’s weighted average coupon rate to less than 4 percent and extended maturities to 15.4 years, dramatically reducing balance sheet pressures.

Some utility stocks have benefited from the resilience of their business model. NextEra and Clearway, for example, have returned roughly 20 and 30 percent year-to-date, respectively. Other stocks, however, continue to lag. And they still present a major opportunity for upside – even if the pandemic lasts longer and wreaks more havoc than most expect.

When a stock trades at big discount to the rest of the market and particularly to its sector peers, there’s always a reason for it. The key question is whether it’s a powerful enough concern to continue the underperformance, and if so for how long?

Earlier this year, I pounded the table to buy AES Corp (NYSE: AES), most recently in the July issue as our Aggressive Focus stock. At that time, shares sold for barely 10 times expected 2020 earnings, despite management’s reaffirmation two weeks earlier that growth targets were intact. Since then, the stock has returned better than 26 percent.

AES is still relatively cheap at 12 times 2020 projections and sells below my highest recommended entry point. But while I’m still bullish on the company, the bigger second half 2020 opportunities in discounted utilities are elsewhere. First Energy (NYSE: FE) and Exelon Corp (NYSE: EXC), for example, sell for just 11 and 12.6 times expected 2020 earnings, due primarily to what should prove to be well overblown political and regulatory concerns. Edison International (NYSE: EIX) sells for 11 times expected 2020 results versus 19.7 times for the Dow Jones Utility Average. The reason is worries about what’s shaping up as a record wildfire season in California.

These are legitimate risks. They’re also very difficult for investors to handicap with accuracy, which is the why these stocks’ valuation discounts are so deep. But if these companies can avoid the worst-case scenarios that current prices reflect, investors are set up for big gains over the next 6 to 12 months. That’s true no matter how long this pandemic is with us.

Editor’s Note: Income-investing expert Roger Conrad has covered utility stocks and essential-service companies for more than two decades. With Conrad’s Utility Investor, you can put Roger’s wealth of experience to work for your portfolio.

The bedrock of the publication, the Utility Report Card includes Roger Conrad’s assessment of 200 essential-services stocks, vital statistics and proprietary Quality Grades to help investors gauge the risk associated with each name. This exhaustive due diligence underpins model Portfolios for aggressive and conservative investors, as well as his Endangered Dividends List, which spotlights troubled names that could be at risk of cutting their payout. Roger Conrad offers high-quality analysis and rational assessment of the best dividend-paying utilities, MLPs and dividend-paying Canadian energy names, visit www.ConradsUtilityInvestor.com.

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