SJW - SJW Group: Recessions Are Like Water Under The Bridge

2023-04-19 02:14:12 ET

Summary

• When you're worried about a recession, you move up to the top of the food chain. Invest in companies that offer something you literally cannot live without.
• This company has outperformed the S&P 500 for as far back as data on Seeking Alpha allows and beaten the market during two of the last three recessions too.
• Buy SJW to support your portfolio in good times and bad. It's been around the block for over a century. Dividend Kings are rare, and SJW is one of them.

Investing despite of recessions

I started my investment career just after the Asian Financial crisis in 1997 and just before the emerging markets crisis began in 1998 sparked by a Russian default on its debt and the devaluation of the ruble. I thought it was crazy and couldn't believe my luck. Had I really decided I wanted to do this for a living? It was a 'jolly' ride back then as Ecuador rolled over in 1998 too followed by Argentina and then Brazil. I Just got through that and of course we then had the dot-com bubble in 2000 followed by further drama in Turkey, Uruguay, and Venezuela (let's not forget the Sept 11 attacks which caused pain stress and angst in 2001 too). I then endured the Great Financial Crisis ((GFC)) or Great Recession in 2007 which became a global phenomenon that was likened to the Great Depression in 1929, that in turn sparked the European sovereign debt crises (remember 'Grexit'?), yes that was 'fun' lots of drama between there and Covid (Brexit for one), which of course was another global event and just as we thought we were finally over that we then got the war in Europe which sparked soaring inflation and interest rates.

From the day I started to today there have been, according to Wikipedia over 40 economic crises and 3 US recessions.

It's been a wild ride looking thinking back, but you know what, I'm still here!! and more importantly for readers out there, so is the market! And this has been the return of the S&P 500 over those periods of stress and drama that span my career.

A 581% total return.

Looking at past recessions this gets even more interesting. Over my career there have been as I said above 3 US recessions, as per Wikipedia these are the details:

Now I thought it would be interesting to see what would have happened if you had purchased shares in the 'market' on the first day of each month that the recession started and compared that to your return at the end of the recession (measured as first day of the month the recession ended) and the return if held up until today.

So quite simply if you had invested your heard earned savings in the market the day the recession started and held on until today you would have seen an immediate and sharp fall followed by potentially life altering returns. Similarly, had I invested when my career started and held on through over forty global economic crises and 3 US recessions my return would have been 581%.

We've seen this story a hundred times before right, slow, and steady wins the race, time in the market is better than timing the market etc.

Now I'm first to admit that this is easier said than done, I can recall a time sitting in the dealing room of my previous employer and feeling stressed about the state of the world in 2007. The media of course was calling end of days, emotions were high, stress was palpable, and panic was rife. An old soul, a legend I had worked with for years then turned to me and said, 'do you remember what happened in 2000 during the dot-com crash and how we felt then' my answer was 'no I can't recall' to which he responded 'exactly' and so we began to slowly buy into the chaos. The moral of this story is simple. In 10 years', time you won't remember the stresses you feel today in this moment they will be long forgotten. This applies to the inevitable market turmoil that arrives when economies battle, and recession looms large. Knowing this allows you to objectively take stock and begin shift though the pieces of the carnage and start picking up your future fortunes as the world melts down around you.

Using this knowledge and gathering on my 25 years of experience this is my recession play book if one comes our way.

Think about Covid it's the freshest time of global crisis we can all remember. During a time when the world literally 'stopped' what were the products and services you never stopped using.

We all need a roof over our heads right, come rain or shine? Food to eat, heating, lights, water, some form of entertainment, a hobby, exercise? the list is long and therein lies your investment universe and you're likely to produce some great investment ideas. If you plan now and make sure you're ready to execute it when trouble comes it may just help you get ahead of your emotions and pull that buy trigger when your stress and angst is begging, you not to!

My first pick is the most obvious, Maslow's hierarchy of needs surmises this best in my opinion. Our largest and most fundamental needs must be met first before we can progress up the layers. These 'basic' or physiological needs include things like air, water, food, shelter, safety, and clothing. Before we have at least these 'simple' things we cannot hope to progress as humans.

And I'm starting right at the top of the chain here which, in my opinion is water.

SJW Group

SJW Group ( SJW ) is a water utility. The company operates in and serves customers in California, Connecticut, Maine, and Texas. It was formed in 1985, as SJW Corp, a California Corporation and subsequently changed in 2016 to 'SJW Group' and a Delaware corporation . They also own SJW Land Company, which owns underdeveloped land in California and Tennessee, and operates commercial buildings in Tennessee.

The company's roots are deep and go all the way back to 1866 when subsidiary 'San Jose Water Company ' was incorporated in the State of California. The business out of Maine ( The Maine Water Company ) similarly has been serving customers in the New England region since 1880.

What is the opportunity?

As a large national pure play water/wastewater company SJW is perfectly positioned to take advantage of several key initiatives impacting its industry today. The Inflation Reduction Act (IRA) and Infrastructure Investment and Jobs Act ((IIJA) naturally include water as part of their focus, in fact $55bn has been allocated to the creation of clean drinking water alone.

The scope and reach of these two laws are vast and likely to last for years to come. On top of this SJW's growth is a multi-pronged approach covering both CAPEX and Acquisitions. Pulling these two levers and sticking to regions and environments where regulation is conducive sets the process up well.

This is a company with a market cap of $2.44bn at the time of writing. Its capex pipeline is $1.4bn. This is needle moving stuff and provides a path for significant growth and investment over the next few years. Over and above this growth by acquisition can level up the company incrementally and all this in an environment of massive government support and initiative.

The track record speaks for itself here. Small bolt on acquisitions that are increasing size, scale, and reach.

Capex has also been consistent and provided an underpin to growth over the years but that's ramping up now courtesy of the government programs alluded to above which is supported further by large natural demand.

Solid growth with a clear see through to returns.

Regulation

This is a regulated company with 97% of net income from regulated sources. The split of which is skewed mostly to California (53%) and Connecticut (33%) with Texas growing rapidly (8%).

Regulated entities require supportive relationships with their regulators and hope to also operate in constructive regulatory environments. Fortunately, this seems to be the case for SJW, and the company considers the teams they engage with at a regulatory level as both experienced and highly regarded.

The California regulatory framework for example provides for forward test years, which allows a 12-month period to be used to establish a pro forma revenue requirement that is determined by projected data. They also allow for a return on acquisition goodwill.

Connecticut has decoupling and infrastructure tracking mechanisms which basically breaks the link between the amount of 'utility' a utility sells and the revenue it collects in order to recover the fixed costs of providing services to customers. This ensures that a utility's revenue from fixed costs remains at the level regulators determine to be fair and reasonable, including a fair return on investment and that customers pay a fair amount for services rendered.

This must be considered one of the major risks to any utility. i.e. the regulatory environment it operates in and we're getting a thumbs up here.

Recession Resilience

Most people investing today or at any time for that matter think about the resistance of a company during recessions. With the US potentially on course for one in 2023 let's see how this company has endured over time and what the impact of a recession is likely to be.

First, this company sits on the top of the food chain when it comes to customer necessity. You may stop buying Nikes ( NKE ) if times get tough, you may stop eating out and perhaps if things are really hard you many even cancel your gym membership or even your Netflix subscription. But you're certainly not going to stop drinking or using water!

Secondly the cost of water is a fraction of household income, it's not likely to bump up your expenses like the recent spike in energy costs did for heating bills for example. In fact, in 2022 the highest average annual cost of water on households in the company's universe was in Texas where it was a mere 1.2% of median household income.

Dividends are oftentimes a good barometer for a company's ability to survive turbulent times. Cut or cancel and business fragility is exposed for the world to see. Did you know that there are just forty-eight companies in the US that are dividend kings? That is, companies that have paid AND increased dividends for at least fifty consecutive years. Well, SJW is on this exclusive list and with current growth projections there's absolutely no reason to believe this winning streak is anywhere close to ending. Looking for a company that's endured market crisis and recessions? Well, this one has paid dividends for 79 years in total and increased them consecutively for 55 years and counting.

Valuation

So how do we value this company? Looking at the peer set we see the following.

Immediately we can see that this sector is richly valued from a PE perspective. It seems like that's what stocks in this part of the market trade at. It might not appeal to a traditional value investor as a result, but one needs to ask why this is the case.

Investing through market cycles with an emphasis on surviving recessions requires businesses with tenacity, endurance, and record of accomplishment. These companies trade at a premium because they are high quality businesses that provide a product or service we literally can't live without. They have earned this premium over time through relentless execution and delivery in any economic environment. In fact, of the immediate peer set above 4 out of six companies are dividend kings! You don't get safer than that.

My assumptions for the company are as follows. SJW can sustain EPS growth of 7% per annum from rate base growth and the capex/investment program. The favourable regulatory jurisdictions they operate in provide optics to price increases and rate base forecasts. Over and above this, cost control and smart acquisitions add support to the view and provide room for an acceleration.

Most jurisdictions, California in particular use Aa bond rates as part of their cost of capital formula. These rates have gone up from 3.1% three years ago to 5% currently. This 200-basis point increase in the pricing input allows leeway in negotiations and provides scope for up to 9.5% return on equity allowances in the calculation. This provides upside risk to earnings.

In summary I'm suggesting high quality necessity-based utilities like SJW will maintain their rating in a recession. Investors will flock to companies with certainty and track record and if that remains true then these are the returns we can look forward to.

Coupled with a 1.9% starting yield that's grown at 9.4% per annum since 2017 and of course a 55year track record of dividend increases implies that investors can look forward to ongoing (earnings related) dividend growth over time.

So, is this stock a recession beater? Let's look at is performance and decide for ourselves.

First up was the recession in 2001, looking at the period 1 March 2001 to 30 November 2001 returns were as follows:

Next up was the GFC, this was a massive recession as we know, the period below highlights 1 December 2007 to 30 June 2009:

Then Covid 1 February 2020 to 30 April 2020:

So, in two out of the last three recessions SJW beat the S&P500 apart from the most recent COVID19 slowdown, perhaps because it was such a quick and short-lived market set back? The longer the 'pain' the more likely stability provided by companies like SJW will be rewarded in my view.

Risks

The primary risk for companies like SJW is of course regulatory risk, I've covered that above in more detail, but this is of course fluid and can change at any time.

After that's there is interest rate risk to consider. Utilities are structured in such a way that they take on debt based on the premise that they can earn a sufficient and adequate return on the debt. Rising interest rates present a challenge that needs to be overcome by price increases and investment returns. Most debt is structured with maturities of more than 5yrs. Current average interest rates on that debt is 3.41%

Droughts are a potential major headwind for companies in this space so water security is a must watch metric. Californian droughts have resulted in mandated conservation from customers to levels 15% below 2019 for example. These things can curb demand and or impact consumption. SJW water sources have exceeded demand for the last 5 years.

Construction risks on CAPEX investment must be considered too. Delays, cost overruns are real threats. Operationally risks from water contamination for example are equally important.

Conclusion

SJW is a safe investment grade holding that can help carry your portfolio through a recession. This dividend king has a track record dating back over one hundred years and as a result has survived several recessions and economic crises over this time including of course 'the Great Depression, the 'GFC' and COVID. It's built to last and has proven itself for over a century.

This is not a go-go stock and is not meant to shoot the lights out. It's an anchor, a ballast and a sleep well at night holding which will not let you down. Current government programs and initiatives have potential to accelerate earnings growth for the near future too which should 'quench' investor return requirements. Over and above all of this, returns over the long term have been phenomenal. SJW has almost doubled the return of the S&P500 for the period dating as far back as data on seeking alpha allows.

Come rain or shine, recession, depression or Armageddon SJW will do you proud. Buy.

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