Despite the overall market’s swings from risk-on to risk-off in response to a slow U.S. recovery, Europe’s ongoing crisis and the Fed’s decision to hold rates at extraordinarily low levels, electric utilities have continued to provide solid total returns for growth-and-income investors seeking lower volatility.
Research asked five experienced electric utility portfolio managers for their thoughts on the sector and its outlook: John Kohli, CFA, CPA, portfolio manager of Franklin Utilities Fund (FKUTX); Oliver Pursche, president, Gary Goldberg Financial Services and co-portfolio manager of GMG Defensive Beta Fund (MPDAX); Maura Shaughnessy, CFA, portfolio manager of MFS Utilities Fund (MMUFX); Douglas Simmons, manager, Fidelity Telecom and Utilities Fund (FIUIX); and Bryan J. Spratt, CFA, research analyst and portfolio manager with Miller/Howard Investments Inc.
Which electric utility sectors do you focus on, and why?
John Kohli, Franklin: I follow all sectors of the electric utility universe, with a specific focus on regulated companies.
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Oliver Pursche, Goldberg Financial Services: The primary focus is on domestic, large-cap electric utilities that have strong balance sheets, strong dividend coverage and dividend histories, and limited nuclear energy exposure. Our flagship dividend income portfolio, the GGFS Dividend Buster Program, has about 23% of its exposure in this sector.
Maura Shaughnessy, MFS: Within the electric utility universe, we focus mostly on the diversified or integrated electric power companies and to a smaller extent on the independent power producers (IPPs) and purely regulated businesses.
Douglas Simmons, Fidelity: All of them: electric, water and gas.
Bryan Spratt, Miller/Howard: I cover the entire utility space, including electric, gas, & water. We manage both diversified equity portfolios such as our Income-Equity (15-plus years) and more concentrated strategies, including our Global Utilities & Infrastructure (20-plus years).
We also manage a utility-consolidation target strategy called the Distribution/Merging Utilities (13-plus years) and a Master Limited Partnership (MLPs) strategy.
How did these sectors perform in 2011 and the first half of 2012?
Kohli: Electric utilities have been among the best performing sectors in the S&P 500 since the beginning of 2011, and regulated companies have been the primary contributor to that positive performance. Regulated utilities have been less sensitive to ongoing global economic uncertainties compared to other industries, because they generally maintain greater levels of earnings and cash flow stability.
Pursche: They had a strong performance in 2011 with marked outperformance of the S&P 500 (+ 6.73% for Dividend Buster Program from 1/1/11 to 6/30/11 compared to +6.02% for S&P 500 for same period; plus, the portfolio outperformed the S&P 500 by 551 basis points in Q2 2011). The sector has underperformed in the first half of 2012 as the markets have become less defensive and money has moved to more growth-oriented stocks. However, it is important to point out that electric utility stocks remain among the highest yielding of all sectors with an average yield of 4.1%.
Shaughnessy: In 2011, in general, integrated companies and IPPs underperformed regulated companies, as investors were searching for “defensive yield,” especially in the back half of the year. The first half of 2012 was more mixed, as regulated companies were generally weak versus other utilities in Q1, and the market took on risk; but many snapped back in Q2 during the market sell-off.
Simmons: There was a very large outperformance (versus the S&P 500) in 2011. The utility index was up 20% inclusive of dividends, compared to a flat S&P 500.
If we look at the first half of 2012, the market has really been all about risk. We’ve seen the S&P up around 12 %, while utilities on average are up around 5% and my funds are up 7%. They’ve lagged the market this year as investors have rotated into risk and out of more traditionally defensive sectors, such as utilities.
Spratt: 2011 was a very good year for electric utilities and the broader utility sector, and the group led the broad equity market. Electric utilities were generally up in the first half 2012, but less than the overall market.
Last year, the utility indexes played some catch-up vs. the broad equity market since the financial storm in 2008. At Miller/Howard, we’ve seen strong absolute and relative results from the utilities we owned across our strategies the last three and a half years and over the long-term.
Are the sectors’ results this year different from what you expected? And, if so, why has that been the case?
Kohli: Heading into 2012, we remained bullish on regulated utilities in the U.S., given low long-term interest rates, high levels of required capital investment, and a global economy facing significant pressures to grow. The overall strength of equities given continued benign economic growth forecasts this year has been surprising, and utilities have underperformed other components of the economy as a result.
Pursche: Recent performance has been in line with expectations as we expected this shift to occur.
Shaughnessy: We assumed that investors, in general, would continue to show interest in many regulated electric power companies, given their high relative yields, and if the market continued to be choppy.
Simmons: Going into the year, I think there was a thought that if there was a bid in the market for riskier assets, utilities would lag, because utilities have less economic sensitivity and have virtually no exposure to Europe. In an environment in which investors are seeking more cyclical and riskier stocks, you would expect utilities to underperform, which they’ve done. From this point forward, I feel the group offers a good risk return after the broader rally we have seen in the market year to date in riskier assets.
Spratt: After the strong results in 2011, we anticipated some bigger-cap electrics to take a breather, and companies like Southern, Con Ed and Dominion did just that. Northeast Utilities moved higher as they completed their merger with NStar. But due to valuation and some potential headwinds from several states’ complaints on transmission allowed returns, we reduced our position in late July. NiSource, a diversified utility, and American Water Works, the largest U.S. public water utility, keep marching forward as they continue to execute on prudently deploying capital, growing earnings power and raising the dividends.
What factors should have the most influence on the returns of electric utility stocks for the intermediate and long-term?
Kohli: Electric utilities will be most impacted by long-term interest rates, just as they have been historically. Dividend payout ratios have been steadily moving higher over the past few years in this sector, increasing the correlation of share prices to interest rates.
Regulation remains an impactful influence on electric utility valuations, but we believe the industry focus over the past several years of strengthening and maintaining their regulatory relationships should help drive more stable share price performance over the intermediate term.
Pursche: The regulatory environment continues to impact the utility sector; however, we believe that commodity prices and the overall interest rate environment play a more significant role in the expected return of electric utility stocks.
Shaughnessy: Over intermediate and longer periods of time, electric utility returns will most likely be influenced by economic growth, as it impacts demand for power and power prices, as well as the regulatory environment as it relates to the rate of return companies can earn on their investments and various changes to energy policies.
Simmons: On the intermediate time front, I think that the regulatory construct around utilities, especially at the state level, is very important. What we’ve seen are supportive regulatory constructs with continued robust returns on equity (or ROE).