Bright Idea

Will you talk about your largest holdings? If you look at the last quarter, we’ve had very strong performance in some of these names. TXU (TXU) and Exelon (EXC), are two that come to mind; a third very large holding is Edison International (EIX). All of these companies have benefited from higher commodities prices. They all have deregulated generation. That’s what we look for because we would expect to see more growth coming out of these companies–more earnings growth, more cash-flow growth–and so far that’s been the case. The price of power is very much tied to the price of natural gas, and natural gas has been moving upward pretty dramatically. That has had a big impact on the performance of those stocks and performance of the fund. In the last few days [the interview took place Oct. 6], there has been a lot of volatility in the commodity markets; these stocks have also been very volatile on the downside. Natural gas prices had moved up so rapidly, the utility group had moved up very rapidly, and now the market is digesting that. We still believe there is going to be upward pressure on commodity prices. We’re not trying to forecast a specific commodity price but we think it’s going to be higher than most other energy analysts are predicting.

Would you talk about some of your winners? Exelon has been a winner–it’s the dominant nuclear power generator in the country, and is in the process of acquiring Public Service Enterprises (PEG), which also has nuclear power in its fleet. With nuclear power, Exelon is generating electricity at a very low cost. Some of its power is deregulated, so it’s able to earn higher returns on that part of the business, because the gas price has been setting the price for power. The returns are going up, margins are expanding, and cash-flow generation is tremendous. With that cash-flow generation, it’s been raising dividends. It’s exactly the kind of company we’re looking for: High quality, strong cash-flow generation, strong business franchise, and the ability to raise dividends at an above-average rate. Exelon made the decision to buy the nuclear power plants early on, when they were very low cost. When other companies that had decided to get out of the generation business were selling them at pennies on the dollar, Exelon was scooping up these assets and now it has a core competency in nuclear.

TXU has similar characteristics but went through much more of a downturn than Exelon. It got into trouble when it invested overseas. Its U.K. business was losing money and it had to take a big write-off. TXU had a retail business where it contracted for power at very high prices, and then the power market collapsed in the U.K. Prices went down, but it was contracted to pay [for power at] much higher prices, and it had to serve its customer base. TXU got out of that business, but that really put it into financial trouble on a short-term basis; the company had to cut its dividend and brought in new management. It’s started to generate a lot more free cash because once it cut the dividend it was able to accumulate cash, pay down some debt, and that put the company on much better footing. Management has done a superior job of working with regulators improving operations, and in addition, it’s got deregulated generation that’s benefiting from the higher commodity costs. TXU is still selling at a significant discount to the group’s multiple, so we think there’s more room for it to grow.

What about companies you’re not as happy with? The utilities definition includes telephone companies, which have not been faring very well because of all the competitive threats they’re facing. Verizon (VZ) has done an extremely good job in its wireless business, but its wireline business–the traditional fixed, plain old telephone service–has been suffering because customers no longer want second lines. They’re using their cell phones. The whole model is changing and the phone companies are changing with it, but it’s hard for them because that plain old telephone service paid a lot of bills. They compete with [each other] for wireless business; the cable companies on broadband; and they’re losing some of their traditional base.

Where would this fund fit in an investor’s portfolio? The utilities have changed a lot, but what I find so compelling about the industry group is that there are a lot of areas in which to invest. You can be very diversified but still stay within the utility group. Investors in utilities can find an investment choice that can produce above-average returns, over time, strong total returns, at below-average risk. Obviously you can’t promise that, but historically that’s what we’ve been able to produce. That’s very compelling, particularly as our baby boomer population gets closer to retirement. They are, I would say, looking for more conservative investments, investments where there is significant dividend income. Utility funds offer above-average dividends; below-average risk, at least historically; a very diversified group of stocks to invest in; and the ability to invest internationally because every country has utility stocks.

Does the Energy Policy Act of 2005 impact the fund? It’s had a positive impact on the fund. PUHCA, the Public Utility Holding Company Act, instituted back in the ’30s, has been repealed. That’s positive because the Act had prevented non-utility companies from investing in the industry. That will encourage more M&A activity in the group, and that’s positive for the performance of the group. It’s also positive in terms of efficiencies in the utility industry. We really have underinvested as a country in our transmission plant, [but] the energy legislation now provides many more incentives for investment in transmission and that’s a positive–for consumers as well as for the companies. Companies that invest in transmission will earn attractive rates of return. More connectivity should lead to lower prices. Say you can generate power at a cheaper cost in the Midwest than you can in the Northeast; it’s hard to get that power to the Northeast–the transmission lines are pretty much over capacity. Better transmission means that you will be able to bring cheaper power into areas of high-cost power, so that should be good.

Staff Editor Kate McBride can be reached at [email protected].