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Why is Bill Gross Buying Utilities?

Posted by Larry Doyle on November 23, 2009 9:35 AM |

Pimco's Bill Gross

Pimco's Bill Gross

There is no doubt that the Fed and Treasury are compelling investors to allocate capital and savings into the market. With savings rates effectively at or near 0%, holding cash is expensive both in terms of no return and opportunity cost. That said, what is one to do when large parts of the market appear to be “bubbling” over due to Uncle Sam’s excessive liquidity and the economy remains strapped?

Let’s check in with one of our Sense on Cents Economic All-Stars, Pimco’s Bill Gross. In his December 2009 Investment Outlook, Gross makes the case for investing in utilities.  Why utilities? As with any investment, we should focus on risk-adjusted returns. Gross provides a reasoned assessment of the current environment and a rationale case for investing in utilities. He writes:

The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until. To date that transition is incomplete, mainly because mortgage refinancing and the purchase of new homes is being thwarted by significant changes in down payment requirements. The Treasury as well, has a significant average life extension of its own debt to foist on investors before the Fed can raise short-term Fed Funds.

OK, so where does that leave you, the individual investor, the small saver who is paying the price of the .01%? Damned if you do, damned if you don’t. Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis? Two suggestions. First, as emphasized in prior Investment Outlooks, the New Normal is likely to be a significantly lower-returning world. Diminished growth, deleveraging, and increased government involvement will temper profits and their eventual distribution to investors in the form of dividends and interest. As banks, auto companies and other corporate models become more regulated and therefore more like utilities and less like Boardwalk and Park Place, they will return less.

Which brings up the second point. If companies are going to move toward a utility model, why suffer the transformational revaluation risk of equities with such a low 2% dividend return? Granted, Warren Buffet went all-in with the Burlington Northern, but in doing so he admitted it was a 100-year bet with a modest potential return. Still, Warren had to do something with his money; the .01% was eating a hole in his pocket too. Let me tell you what I’m doing. I don’t have the long-term investment objectives of Berkshire Hathaway, so I’m sort of closer to an average investor in that regard. If that’s the case, I figure, why not just buy utilities if that’s what the future American capitalistic model is likely to resemble. Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom. Their growth in earnings should mimic the U.S. economy as they always have, and most importantly they yield 5-6% not .01%! In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity. Utilities and even quasi-utility telecommunication companies now yield between 5 and 6%, whereas their 10- and 30-year bonds yield less and at a higher tax rate to you the investor.

Gross runs the largest bond fund in the industry. In highlighting the relative value of utilities, he is not ‘talking his book.’

LD

  • TeakWoodKite

    LD, I saw an article recently that had Wells Fargo dumping 1.1 trillion of loans on the FHA saying they were not required to lay in reserves as required by Treasury. I can see why you point to this sector as it would not require one to transit this dangerous part of the train station platform.

  • TeakWoodKite

    Thanks for what you doing. Best.

  • Warren Buffett is one of the best investors and the richest men in the world. I definitely can applause his work. really it is good to know the investment strategy of this businessman.

  • Because PIMCO is a real estate developer with interests in giant malls. Remuneration for those SWEET rates they get?

    A wild guess.






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