Bet on Europe's utilities and grocers as inflation rises

LONDON (Reuters) - There is no way to fully inflation-proof an equity portfolio, but Europe's utilities and food retailers may be the best bet in the current period of soaring commodity prices and an uncertain economic outlook.

Consumers need only take a car trip to the supermarket or glance at their gas and electricity bills to see how the surge in commodity prices has trickled down and sparked concern among central bankers struggling to beef up their slowing economies.

Prices of basic foods such as wheat, corn, coffee and cocoa have racked up double-digit percentage gains this year, along with oil and precious and base metals.

For an equity investor, defensive stocks such as the food and beverage sector, utilities, drug makers or tobacco firms traditionally do well when consumers tighten their belts.

The key to riding this wave of inflation is to buy into companies that service unavoidable consumer needs, like switching on a light or turning on a tap at home.

"Utilities certainly are a big winner here," said Ian Richards, a European equity strategist at ABN AMRO.

The diverse pricing structures of the wholesale European power markets and the complexities involved in retail pricing mean that the method of passing on rising energy prices to consumers is not always very transparent.

Analysts say power generating companies are more likely to benefit from higher oil prices than companies that focus more on distributing, which can face backlashes from governments and consumers when household electricity and gas bills rise sharply.

"I'm not sure companies feel they can stick that (the price rises) through to the consumer without a problem. You look at the likes of Centrica, which has been hit in the past when that's happened. But if you're British Energy BGY.L then you've got a great story to tell here," ABN AMRO's Richards said.

In Britain, Germany's E.ON EONG.DE, the world's largest utility, raised average electricity prices to consumers by 9.7 percent in February, while British Gas, a unit of Centrica (CNA.L) raised prices by 15 percent, according to uSwitch.com, a utilities price comparison service.

SUPERMARKET SWEEP

Food and drinks makers are coping with soaring costs for basics such as corn, wheat and sugar, but it is the supermarkets that will likely reap the most benefit from these increases.

So far, the likes of Nestle (NESN.VX), the maker of Nescafe instant coffee and KitKat chocolate bars, and Unilever (UNc.AS), the name behind Lipton tea, have been able to pass rising raw material costs along to end-consumers. But this is unlikely to be the case for the whole sector.

"Unless you're someone like Nestle, who have need-to-have brands, you're going to find passing the full price increase of your raw materials through quite difficult," said Andrew Lynch, a portfolio manager at Schroders.

"The food retailers, the Tescos (TSCO.L) and Carrefours (CARR.PA) of the world ... can manage to disguise quite effectively to the average person on the street food inflation by special offers here and discounts there, and get a lot of prominence while quietly pushing up the price of a loaf of bread by 10 percent in three months. That's why I own much more in food retail."

Looking at European valuations, investors are willing to pay the biggest premium for food and beverage producers. The estimated one-year price-to-earnings ratio for the DJ Stoxx index of food and beverage companies .SX3P is 16.7, followed by the index of personal and household goods .SXQP with a multiple of 14.5 and utilities .SX6P with a multiple of 14.4.

The lowest valuations are, unsurprisingly, those of the financials, with insurers .SXIP at 7.7 and banks .SX7P at 8.2. This compares with a multiple of 10.7 for the pan-European FTSEurofirst 300 index of leading European shares .FTEU3.

Basic resources stocks -- the star performers of 2007 thanks to merger activity and sky-high base and precious metals prices -- have been a key commodities play, given their cyclical nature and subsequent demand from emerging economies for raw materials.

But commodity price inflation has raised the chances of a slowdown in global growth and with it a contraction in demand for base metals such as copper, the backbone of the electronics industry, or nickel, the key ingredient in stainless steel.

Investors in oil producers, for whom the price of crude oil has virtually doubled in the last year with the rise above $100 a barrel, have not seen such handsome returns from their equity holdings.

The DJ Stoxx index of European oil and gas producers .SXEP has fallen by more than 17 percent in 2008 and is down 8 percent in the last 12 months.

"It's going to be difficult to put some prices up. The price of petrol at the pump and the oil in your heating tank -- these are global markets and as competitive as they can get," said Roger Noddings, chief investment officer at HSBC Investments.

"Some spending is more discretionary than others. At the very discretionary end of the spending spectrum it's going to be pretty tough."

(editing by Elizabeth Fullerton)