When Enron filed for bankruptcy in 2001, utilities funds collapsed--losing 21.1 percent for the year. The losses continued in 2002, as investors worried that power markets faced more blow-ups. But soon the clouds cleared. The troubles seemed limited to a few scandal-plagued companies. Analysts became convinced that many markets faced substantial power shortages. The change in attitudes set off a bull market in utility stocks. During the three years ending April 30, 2007, utilities funds returned 25.3 percent annually, ranking as one of the top-performing categories tracked by Morningstar.
The outlook for utilities funds remains solid. While regulators are encouraging plant construction, few coal and nuclear facilities are being completed because of environmental concerns. With demand for power increasing relentlessly, companies are likely to report growing earnings and revenues for years. Coal and nuclear facilities could do particularly well. At a time when prices of natural gas are steep, plants that use competing fuels have room to raise prices and fatten margins.
In addition, many utilities funds hold telecom issues, which could provide a boost. While landline business is declining, cellular traffic continues to boom, helping to prop up stocks.
Which fund is the best choice? To make a selection, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alphas and Sharpe ratios must also surpass the medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.
The screens reduced the field from 71 to 20 choices. Top contenders included JHT Utilities, Evergreen Utility & Telecommunications, and Eaton Vance Utilities. But we awarded the title to MFS Utilities, which had the highest five-year returns.
MFS took the lead by following a wide-ranging style. Searching for bargain investments, veteran portfolio manager Maura Shaughnessy often holds bonds and big foreign positions. A contrarian, Shaughnessy loves to buy stocks that have just collapsed. In 2002, she became interested in AES, which owns independent power plants, a business that seemed headed the way of Enron. With the common shares selling for less than 2, Shaughnessy bought the company's bonds. "The business had some solid assets, and the bonds seemed like the safest way to participate," says Shaughnessy.
AES recovered nicely, and the bonds produced stock-like returns. Shaughnessy then traded the bonds for common shares, which continued rising, producing outsized results. Besides delivering solid returns, the fund's bond holdings have helped to stabilize the portfolio, enabling the fund to maintain a standard deviation that is about average for the category.
Another contrarian move occurred when Shaughnessy pounced on depressed shares of Public Service Enterprise Group last year. The New Jersey utility was supposed to be acquired at a premium by another company. Expecting a rich takeover, investors pushed up the price of the stock. When the deal fell through, the shares collapsed from above 70 to below 60. Shaughnessy figured that the shares would rebound because New Jersey faces a power shortage, and a new management seemed positioned to take advantage of the growing market. The MFS fund's move proved well-timed. In the past year, the shares have risen to above 90.
The fund's biggest holding is NRG, an independent power producer. The fund began buying stock and convertible bonds of the company just it was emerging from bankruptcy three years ago. Since then, the power company has retired much of its debt, and the stock has soared.
Though many of her holdings have troubled pasts, Shaughnessy does not buy unless the company seems poised to enjoy strong growth in the future. She favors generation companies that seem likely to increase their power production in the next several years. Among her most successful holdings have been cellular providers in foreign companies that seem positioned to expand rapidly. The MFS fund has enjoyed success with Rogers Communications, a Canadian company that has been moving into new markets. "Canada has one of the lowest penetrations of wireless markets in the developed world," says Shaughnessy. "The country is two years behind the U.S. in building the wireless networks."
The fund also owns cellular stocks in emerging markets, where companies are racing to provide consumers with new telecommunications services. A favorite holding is America Movil, a Mexican company that is expanding in its home territory as well in Argentina and Brazil.
The fund can keep up to 35 percent of its asset in foreign markets, and Shaughnessy is currently near her upper limit. In recent years, the foreign exposure has given MFS an advantage over competitors, which tend to hold smaller international positions. Utility stocks have enjoyed big runs in Europe and other overseas areas as demand for power grows.
Besides power and telephone stocks, Shaughnessy also buys media and energy companies. But she makes no effort to diversify the portfolio by sectors. "I don't pay attention to the sector allocations at all," she says. "We go wherever we can find the most promising stocks."
That opportunistic attitude has enabled the fund to lead the pack. With power shortages looming around the world, the MFS fund should continue delivering healthy results.
Stan Luxenberg (firstname.lastname@example.org) is a New York-based freelance business writer and has long been a regular contributor to Wealth Manager.