When investors get nervous about the stock market, they generally take one of three common paths with their money. The first choice is the flight to cash, a mistake that many investors made in 2008 and 2009 just in time to miss a massive recovery. The second is the low-risk low-reward move into short-term and intermediate-term bonds. The third move is to roll into defensive stocks that pay solid dividends and can keep paying those dividends even in hard times.
It is the third path that offers investors the most upside or the best current income. It is also the third path that is the most interesting. Defensive stocks rule here, generally in utilities, food and tobacco, and basic consumer products that have to be bought in good times and bad times.
Now comes the big dilemma. Sometimes those safe and steady defensive dividend-paying stocks become incredibly popular. When stocks become too popular, they can also become too expensive. As of Thursday, February 18, 2015, the S&P 500 was valued at roughly 16.2 times the estimated 2016 earnings per share, according to Standard & Poor’s. The cheap/expensive line historically is between 15 and 16, and last week at the selling peak the S&P 500 was valued at 15.8 times forward EPS.
Many defensive stocks have traded at a premium to the broader market for some time. Some of these safe defensive stocks have become very crowded. This is from investors piling in endless amounts of cash so that the share prices have risen and risen. Some of these are even trading above what Wall Street analysts will agree the fair value estimates should be. The S&P 500 is still down for the year, but that isn’t the case in these defensive stocks.
American Water Works
This remains the best-run water company and the best water stock for investors with a long-term outlook. In fact, American Water Works Co. Inc. (NYSE: AWK) is among our own 10 stocks to own for the next decade. That being said, this water utility giant’s stock has started trading with a mega premium to utilities. Its most recent $65.81 share price values the stock at 25 times the expected $2.63 earnings per share (EPS) for 2016 and 23.3 times the expected $2.82 per share for 2017.
American Water is also at a premium to the consensus analyst target price of $63.36, and it has a 52-week trading range of $48.36 to $66.78. American Water Works now has a dividend for new investors of only 2.0%. It seems easy to see why investors are driving up the value largest water utility stock in America. The reality is that American Water Works always trades at a premium price-to-earnings (P/E) ratio versus the market, and it should trade at a premium, but this seems high, even if the long-term trajectory is probably higher rather than lower.