Gas utility stock outperformance lapses as market turns to growth, reflation

Gas utility stocks roughly kept pace with the broader market in the first half of 2021, even as investors' focus shifted away from the space in the second quarter.

An index of selected gas distributors rose nearly 11% in the first half of the year, trailing the S&P 500's 14.4% year-to-date performance. The gas utility index outperformed the broader market throughout much of the year, but turned lower in the final days of June as the S&P 500 tacked on gains.

Looking at the second quarter, the divergence occurred earlier, with gas utility stocks consistently underperforming the S&P 500 since mid-May and briefly trailing the broader utilities space. The select index posted a nearly 1.7% gain on the quarter, compared with the S&P 500's 8.2% surge and the S&P 500 Utilities sector's 1.1% decline.

Investors have once again sidelined the sector as they focus on rotating into the reflation trade, according to Nasdaq IR Intelligence senior analyst Massud Ghaussy. The reflation trade is a bet on assets that typically rise with an improving economy and inflation. That has lately benefited energy, financials, growth stocks and companies whose fortunes are tied to the business cycle, Ghaussy said in an interview.

"To the extent that value and cyclicals were outperforming earlier in the quarter, utilities didn't really benefit," he said. "And to the extent that growth is now outperforming value over the last few weeks, again, it's not helping utilities. So utilities continue to be an afterthought."

Just three stocks in the select index — South Jersey Industries Inc., UGI Corp. and Chesapeake Utilities Corp. — posted quarterly gains. New Jersey Resources Corp. finished the quarter down slightly, while Spire Inc., Northwest Natural Holding Co. and Atmos Energy Corp. fell more than 2% during the period. ONE Gas Inc. and Southwest Gas Holdings Inc. slumped about 3.6%.

There is little fresh capital flowing into utilities, and investors are largely light on exposure to the sector, Ghaussy added. Finally, the market's focus on inflation presents an "Achilles heel" for utilities, and the sector typically underperforms before Treasury yields start to rise, he noted.

However, sentiment around gas utilities is at least improving in his view. February's winter storms and electric grid crisis burnished the image of gas distribution systems, which were largely unaffected, casting fresh doubt on policies to phase out gas utility service, Ghaussy said. Research analysts also walked away from the American Gas Association's Financial Forum in May sounding a positive note, he added.

"We're impressed with the upbeat, optimistic tones from nearly all companies with whom we met," Scotiabank wrote in a May 24 research note following the event. "Even at a fossil fuel industry event, companies touted growth opportunities largely focused on improving safety and reducing carbon and methane emissions."

Analysts also noted a renewed focus on mergers and acquisitions at the forum, following a lofty valuation on CenterPoint Energy Inc.'s sale of its Arkansas and Oklahoma gas utilities. While that valuation could present a hurdle to deal-making, it also underscored the value of distribution companies.

Hennessy Funds Gas Utility Fund portfolio manager Josh Wein noted that gas utilities continued to post strong earnings and dividend growth during May's quarterly reporting period. "It looked like a good quarter to me, but I think that it's just going to be a long time," Wein said. "I think you need a really severe sell-off in the Nasdaq and some of these more growthy areas."