UK Edition
Determining which companies will excel in an era of high inflation is not an exact science. Judgment is required to decide whether a business can make itself more efficient to keep its costs down despite rapidly increasing prices, or successfully pass its own rising costs on to customers without experiencing a commensurate fall in demand.
Similarly, the wider implications of rampant inflation, such as rapidly rising interest rates and a resulting slowdown in economic growth, can have an unpredictable effect on a company’s earnings. As a result, there is always an element of guesswork when it comes to selecting stocks that can successfully overcome the 10pc rate of inflation expected later this year.
However, in Questor’s view water services business Severn Trent offers a compelling investment case while inflation is at a 40-year high. The company said last week in its full-year results that it had delivered a financial performance in line with previous guidance.
Crucially during a period of rapid price rises, the company’s revenues are linked to the rate of inflation. In addition, its latest results showed that it had made progress in reducing the impact of rising costs through measures such as energy self‑generation, which now meets more than 50pc of its needs, and improved efficiencies in its retail operations.
This should allow Severn Trent to raise its dividends in line with inflation during the current regulatory period, which runs until 2025.
The company’s extremely favourable dividend policy during a period of high inflation adequately compensates investors for its relatively limited yield. Its 3.5pc dividend yield is only fractionally more than the FTSE 100 average and lags several other large stocks. However, those companies’ more cyclical nature and less reliable financial prospects mean their future dividend growth could be limited relative to Severn Trent’s.
The company’s shares offer significant defensive appeal amid the evolving economic outlook. A side effect of high inflation is rising interest rates, which are expected to reach 2.5pc by the middle of next year.
This prospect has already contributed to a downgrade in the IMF’s outlook for the economy, which is now expected to grow at the slowest pace among G7 nations next year. As a result, those businesses whose revenues are less tied to the performance of the economy are likely to gain popularity among investors.
Certainly, the cost of living crisis means Severn Trent must brace for a rise in bad debts as consumers struggle to pay their bills. But a 39pc reduction in bad debts in the latest financial year – they now account for just 2.1pc of its revenues from households – suggests it starts from a strong position.
Its solid financial position also adds to its investment appeal. Like most utilities, it operates with a large amount of debt in order to improve returns. Net debt currently stands at £6.5bn, which amounts to a gearing ratio of around 60pc. But this need not be considered a “red flag” for investors thanks to the robust nature of the company’s revenues.
Moreover, in recent years it has made a concerted effort to switch from index-linked debt to fixed-rate debt, to the point that 69pc of its borrowings are now at fixed rates that are unaffected by rising interest rates or high inflation.
Inflation can even be expected to have a positive effect on its financial position, since it increases the value of its assets and, if the value of its debt doesn’t change, therefore reduces gearing. The 5 percentage point reduction in gearing achieved last year could be repeated in future if, as expected, inflation remains rampant.
Over the past year Severn Trent’s share price has gained almost 20pc as investors have switched to defensive stocks with inflation-beating credentials. But in Questor’s view, the company’s yield suggests that it is not yet overvalued.
Given its dividend growth prospects, inflation‑linked revenues that are highly resistant to an economic downturn and relatively sound financial position, it offers investment appeal on a long-term view.
Questor says: buy
Ticker: SVT
Share price at close: £29.39
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