Generating Steady Income

Electric utilities have continued to provide investors with reliable income in an era of low market yields. We asked five experienced electric utility portfolio managers for their thoughts and outlook on the sector: John Kohli, CFA, portfolio manager of the Franklin Utilities Fund (FKUTX); Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund (MPDAX); Maura Shaughnessy, CFA, portfolio manager of the MFS Utilities Fund (MMUFX); Douglas Simmons, portfolio manager of the Fidelity Telecom and Utilities Fund (FIUIX) and Bryan J. Spratt, CFA, portfolio manager and research analyst with Miller/Howard Investments.

Which sectors of the electric utility universe do you focus on?

John Kohli, Franklin: We follow all sectors of the electric utility universe, including the more market-based integrated companies and independent power producers (IPPs). We maintain a specific focus on regulated companies.

Oliver Pursche, Goldberg Financial Services: Municipal and regional public electric utilities.

Maura Shaughnessy, MFS: Within electric utilities, we typically own mostly integrated and, to a smaller extent, independent and fully regulated companies.

Douglas Simmons, Fidelity: I focus on all aspects of the utility universe—electric, gas and water, in addition to looking at pipeline companies.

Bryan Spratt, Miller/Howard: Utilities are a core focus for Miller/Howard, as our firm’s initial investment strategy in the early 1990s was in fact a dedicated utilities portfolio, and nearly all of our portfolios maintain varying degrees of utility exposure.

Our investable universe includes all utilities—water, gas, telecom, electric and Federal Energy Regulatory Commission (or FERC)-regulated pipelines. Companies within our portfolio participate in regulated service, as well as competitive generation and renewable and other non-regulated businesses.

Have the sectors performed as you expected recently?

Kohli: We’ve been comfortable continuing to own regulated utilities. We like the fact that capital spending remains healthy, generating decent growth in the overall rate base.

Utilities have also done a great job communicating with their regulators to insure that this spending is prudent and gets favorable earnings treatment. Although regulated utilities have underperformed the S&P 500 in 2013, we are satisfied with the positive absolute returns these companies have provided. We recognize the fact that utilities historically underperform during equity bull markets, and that is precisely what has been happening in 2013.

Pursche: While we were pleasantly surprised by the strong performance in 2012 and early 2013, we were equally unpleasantly surprised by the sharp correction in the sector over the past three months. While electric utilities had demonstrated a certain immunity to interest rate risk, the recent sharp rise in yields and concerns over further spikes, along with ongoing revenue and earnings weakness, appears to have caused a significant shift in investor sentiment.

Shaughnessy: The different segments within electric utilities have generally performed as expected. This is typically based off of investors’ risk appetite and yield interest.

When risk appetite is low and investors are searching for yield, regulated higher yielding utilities tend to outperform. The reverse of this environment tends to favor independent and more integrated utilities that are more economically sensitive.

Simmons: Going into the year, I thought you needed to be particularly cautious with your yield exposure. My expectations and what I tried to focus on were the names that were in a position to grow their dividends aggressively.

I think some of the regulated utilities, which are exposed to natural gas infrastructure, have actually done particularly well and have kept up with the market and in some cases exceeded the market. The more commodity-sensitive utilities, which are the deregulated utilities, have really continued to lag. I’ve largely shied away from those names. The commodity-sensitive names, which are the deregulated utilities, have continued to see lower earnings revisions and weaker stock prices in the face of weak commodities.

Which factors have the most influence on electric utility returns?

Kohli: Two factors weigh most heavily on electric utilities. First is the impact of long-term interest rate movements. We’ve seen in the second half of 2013 negative performance of utility stocks due to the steady rise of rates. Utility managements have signaled for higher dividend growth than we’ve seen in the past several years, so this might help offset higher interest rate movements as dividend yields readjust.

The second major factor for performance is regulation. We continue to 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: It is fairly obvious that interest rate moves will have the greatest short-term impact on electric utilities, followed by the regulatory landscape. Weather patterns are reasonably cyclical and are least likely to have any significant impact. However, economic growth, the health of municipalities and therefore the ability for utilities to pass on cost increases will also play a role in stock performance.

Given the current landscape and the likelihood of a further steepening of the yield curve, our outlook for the sector in the short to intermediate term is somewhat bearish, with an expectation of underperforming other higher yielding sectors (for instance, consumer staple, food and beverage, and large pharmaceuticals). Nonetheless, patient income-oriented investors should not abandon the area as the long-term outlook is still constructive.

Shaughnessy: Over the intermediate to long term, which I’ll define as several to many years in length, electric utilities should be influenced mostly by economic growth and the regulatory environment. Interest rates will most likely have some influence on the space, as utilities and other higher yielding sectors tend to face headwinds during periods of significant and quick moves up in rates.

Simmons: I think the biggest driver in the intermediate term is certainly interest rates, because the group is somewhat of a bond proxy; and as bonds move down with higher rates, utilities tend to move down in sympathy. On the deregulated side, I would say that power and gas prices are going to be one of the longer-term drivers of the group. That’s due to the importance of power prices on regulated power companies’ earnings and stock prices.