The Dangers of Equating Bank Stocks with Utilities

Utilities

Bank stocks and utility stocks do have some things in common, such as high earnings and good dividends. The two are very distinct in some very important ways though.

There are actually quite a few investors out there who call themselves conservative, and at least think that they are, who invest in bank stocks for their higher dividends and think that this is akin to buying stock in utility companies. This misunderstands the nature of bank stocks though and risks making some very expensive mistakes.

We should actually quite readily see this as a crazy idea, due to the fact that bank stocks are quite volatile, and utility stocks are famous for their low volatility. Utility stocks are as close to a fixed income investment as you can get with common stocks, and actually are often preferable to bonds given that their prices are often even more stable than bonds are while producing superior returns a lot of the time, which is a nice combination indeed for a conservative investor.

With investments that we are primarily seeking dividend returns from, what we want is low volatility to minimize the effect of drawdowns, in other words investments that can be counted on to deliver the income we want without having us lose a bunch of money on them due to their prices dropping.

We will give up a fair bit of upside to do this but if this type of investment is right for us, that’s exactly what we want to be doing, sacrificing potential capital growth to keep the potential for capital losses fairly low.

Stocks are classified according to how they move when the market moves, where we assign a beta value to represent. A beta of 1 means that a stock moves similarly to how the market moves. Stocks that move more, generally in both directions, are high beta stocks, and a lot of technology stocks are like this. When the market goes up, they go up more, and when the market goes down, they go down more.

People who primarily are after dividends need to be seeking the opposite of this, low beta stocks and preferably the lowest beta ones out there that pay the kind of dividends that these people are after. Utility stocks fit the bill quite nicely here.

The other component in this equation is how cyclical a stock happens to be. The more a stock moves up and down with business and economic cycles, the more cyclical they are. Utility stocks have a fairly constant demand and their growth is limited by regulation so they are also a great choice among common stocks in this regard.

The stability of their business also adds reliability to their performance, even though they can still go down a lot if they meet big challenges like the California wildfires are doing to utility stocks there. For the most part though the risks are considerably less than the sort of things that other sectors have to deal with as far as business risk goes, and this is a plus for them.

The Extra Dividends with Bank Stocks Don’t Go Very Far If Things Turn Sour

Bank stocks might pay good dividends but that’s where the comparison with utility stocks ends. They can be quite volatile, and they also are very sensitive to economic cycles, whether that be in terms of growth, inflation, or interest rates. In the right hands, bank stocks can provide overall returns well in excess of what utility stocks yield, if you are investing in the right bank stocks that is and are only in it for the rides up and not the rides down as well.

This does not fit the profile of those who primarily seek income from their investments, and they are perhaps as far away as you can get from wanting to manage your portfolio this closely. They also tend to be older, and if the intention is just to blindly hold on to them during downturns and hope that you have enough time to get even again, not having as much time as many other investors is another strike against this strategy and a pretty big one at that.

Morgan Stanley’s Betty Grasek has recently commented on the propensity of people to confuse utility and bank stocks, and there are plenty of people out there these days who do. She remarks that she does not feel that bank stocks are somehow morphing into utilities, something that should be quite obvious to anyone with much of a notion of the differences between them.

She points out that while the banking sector may have strong earnings these days, “earnings go down in a recession. They do have recession risk.”

Recession risk is just one of the risks involved with bank stocks, although we could further define this as banks having a lot of market risk. There aren’t a lot of stocks that don’t have a lot of market risk in fact, and analysts as a whole do not account for market risk anywhere near as much as they need to, but when the market goes down, bank stocks tend to follow and often even lead.

The biggest characteristic with utility stocks is that their market risk is so low, and this is the main reason why they can be such a good choice for those seeking dividends primarily, as well as anyone who is looking to hedge market pullbacks or even bear markets. Some utility stocks do better than others, but as a sector, their risk here is as low as you will ever see with a type of stock.

The reason for this is that the demand for the services that utility companies provide is very inelastic compared to other sectors, because people need these services in both good and bad times. People will cut out a lot of things when money is tighter but spending on utilities is the last to go, and in a time of crisis, when they can’t pay, people will still use them until they get cut off.

Banks are especially sensitive to economic conditions, perhaps in a way that no other type of stock is, and they therefore may even be seen at the far end of the spectrum from utilities. If the market is going up and your earnings are going up, we would certainly expect that your stock would go up, but with a bank stock, they can go down during these times.

Banks are especially prone to interest rate worries. When interest rates rise, people worry about growth. When interest rates fall, this can have them worrying as well, about profitability this time. Sometimes it may even appear that you can’t win with this, when changes in both directions producing disappointment in a bank’s stock performance.

Low P/E and Higher Volatility Is Not a Safe Combination at All

We can also see some pretty terrible price to earnings ratio, and if you are of the sort that you like things like 10:1, half the P/E of the market basically, you might be even more tempted by a lot of bank stocks. This may especially be the case if you are a dividend seeker as the yields will be higher if the P/E is low.

The yields may be higher in this case, but that means that the stock just isn’t one that the market likes very much, and the market is the one that decides where a stock’s price is going. Investing in stocks that are not liked very much now are particularly at risk of having this relative dislike continue, something that does not bode well at all for the capital gain or loss side of the trade, which is ever present even if we choose to pretend it is not.

The Invesco KBW Regional Bank ETF is a good example of a fund with a P/E around 10. It has lost 17% over the last year, while the broader market has gained 2%. Investors in this fund can boast about their 3% average yield, compared to the S&P’s 2.3, but an extra 0.7% hardly makes up for a comparative loss of 19%.

If you instead went with JPMorgan Chase stock, the industry leader, you would have still given up 7% to the market over this time, and that’s a loss that is 10 times bigger than the extra dividends that you would have earned.

There was no recession here, but there is plenty to be concerned about with this approach than just recessions, as we can see. If a real recession comes, then really look out below, and even JPMorgan Chase dropped 70% during the last one. Being caught in a mess like this is not something anyone should ever want, and if you are prone to clinging to your paltry extra dividends come what may, what may come may be pretty grim indeed.

This does not mean that investing in bank stocks is necessarily a bad idea, and they can actually be quite good investments if we select and time them properly, but timing anything is well beyond the ability and desire of dividend investors and these investors may be as far away as you can get from this.

Dividend investing can still be a good choice for some people if they choose the right stocks, but choosing bank stocks for their dividends is simply a terrible idea. It sure doesn’t hurt that they pay 0.7% more a year than your average stock, but they move a lot and if you are in them at the wrong time, when they underperform the market a lot, you will be made to pay dearly for this mistake.

There is a lot more potential to make money from capital gains than with dividends, but shooting for capital gains means that you have to bear capital losses if you hang on to your stocks well past their time. These are investors who are almost certainly going to be doing that, and the idea behind utility stocks is to allow them to do this without worrying too much about capital losses, much less than with your average stock. With bank stocks, you have to worry about such things even more.

It may not be a bad idea at all to just plop down some money on a stock as solid as JPMorgan Chase and see you in 30 years. If you’ll be long dead in 30 years, or in some cases less than 10, this is not a gamble you are even equipped to make.

Investing in bank stocks for dividends is simply a bad idea that is especially crazy for older conservative investors to want to get caught up in. If they do want to dabble in utility stocks, at least they are managing the risks involved fairly well, even though this might not be an approach that an investor with more time and risk tolerance would necessarily want to make.

Still though, the utility play is still a relatively safe bet and this strategy is all about safety. Whether it is the best approach for this type of investor is one thing, but we do know for sure that you can’t just rely on a bank’s stock being stable enough or economically insensitive enough for their purposes, and they therefore should just say no to this idea because it is totally unsuitable.

Ken Stephens

Chief Editor, MarketReview.com