FTSE 350: Choppy seas ahead for UK water

The water companies submitted their business plans for the next review period at the back end of last year. In a move clearly designed to demonstrate their keen awareness of the raging cost-of-living debate, their plans included promises to freeze water bill increases and hand back tax rebates to customers. Yet even that appeared insufficient to placate the regulator, which responded by saying it would extend its query process, giving water companies "further opportunity to secure the best possible outcome for customers".

Ofwat is clearly getting tough and with its final decision not due until December, water companies face a year of wrangling and uncertainty, which is likely to weigh on shares. Analysts at Credit Suisse point out that UK water companies tend to underperform in the year before a new pricing period starts and see their premium to regulated asset base shrink. Exacerbating the usual pattern this time around is the fact that the new regime is likely to be particularly unforgiving. The broker advises investors to steer clear: "we recommend that investors avoid UK water, which is facing tough regulation from 2015".

The uncertainty began to make itself felt on share prices from the middle of last year. All three stocks lagged the wider market over 2013 as a whole, with a measly 4 per cent average gain versus the FTSE All-Share's 17 per cent rise. The best performer was Severn Trent (SVT) as its shares ramped up on bid speculation during the summer. But we took Severn Trent down from a hold to a sell during the water companies' reporting season in late November as we felt the valuation was stretched and regulatory risks could put the brakes on any M&A activity in the near term. The shares have indeed pulled back since then.

At the same time, we took Pennon (PNN) off a sell and moved it to a hold as we believed its troubled recycling division Viridor could be steadying and the shares have since enjoyed a bounce. Finally, we moved United Utilities (UU.) to a buy from a hold as, having lagged peers, we believe the valuation and dividend yield look attractive.

FAVOURITES:

With the chunkiest dividend yield on offer and as last year's laggard, United Utilities looks the best of the bunch for anyone wanting to stay invested in UK water this year.

OUTSIDERS:

Severn Trent is our least preferred pick as we believe its rating, which has been inflated by bid hopes, looks vulnerable amid the rising regulatory risk and uncertainty. At the time of the results in November, Severn Trent was trading at an 18 per cent premium to regulatory asset value against United Utilities on only a 7 per cent premium.