Year to date global utilities in the MSCI World Utilities index have underperformed global equity markets – the MSCI World index – by around three percentage points in sterling terms.
This continues a broad trend of underperformance that has seen the utilities index lag the world index for four out of the last five years (2014 was the exception). To offer some insight into the scale of this protracted underperformance, £100 invested in the MSCI World Utilities index on 31 December 2011 would have become £182 on 31 December 2016, while a similar investment in the MSCI World index would have been worth £228.
However, while global equities look to be quite fully valued relative to history, utilities valuations look much less demanding. The MSCI World Utilities index is currently trading on a P/E ratio of 17.2x, which is 18.8 per cent below its five-year average of 21.2x, while the MSCI World Index is trading on a P/E of 21.9x, which is 20.7 per cent above its five-year average of 18.1x.
Utilities tend to be defensive in nature. Once established, they are usually cash-generative businesses with earnings that are relatively stable, often with some degree of inflation protection and commonly tied to long-term contracts. This allows them to have fairly predictable income streams, which is a key attraction for many investors. It also allows them to safely take on higher levels of debt (utilities are usually capital-intensive businesses), which means the market tends to view interest rate rises as being a significant negative for utilities. Furthermore, while their stable earnings mean that they’re likely to outperform a falling market, they’re also likely to underperform markets benefiting from a cyclical rally, which has been part of the challenge in recent years.
Here in the UK, the market seems to have shrugged off its Brexit worries so it is now trading at or close to all-time highs. A similar phenomenon can be seen in the US. Having pushed initial concerns regarding President Trump aside, its market is romping ahead as it looks forward to a more business-friendly administration, fiscal stimulus and significant infrastructure spend. There is no obvious reason to say these markets can’t move to even greater highs but looking forward there are many challenges ahead that could derail the current consensus. In this environment, utilities would likely perform relatively well and so perhaps warrant another look.
Bearing in mind that at QuotedData we do not seek to make specific stock recommendations, it is worth examining the two investment trusts focused on the utilities sector: Premier Energy & Water Trust (PEW) and Ecofin Global Utilities and Infrastructure Trust (EGL).
PEW is managed by James Smith and Claire Long at Premier Asset Management. The portfolio has a strong bias towards emerging markets where the managers say they’re able to benefit from both a less well researched market as well as higher structural growth.
PEW also has a relatively high level of gearing provided by its zero dividend preference share (its ZDP borrowings are equivalent to 43 per cent of its ordinary shares net assets). This means its returns can be quite volatile but it is able to generate a higher level of income for its ordinary shares. It pays quarterly dividends and its ordinary shares currently offer a 5.8 per cent yield. It is also available at a 10.8 per cent discount to NAV.
EGL, in comparison, is focused on developed market utilities. It is managed by Jean Hugues De Lamaze at Ecofin, which specialises in investing in the global utility, infrastructure, alternative energy and environmental sectors. Like PEW, EGL also pays quarterly dividends and offers a high yield (5.5 per cent) but it has a much lower level of borrowing that is provided by traditional bank debt (13 per cent of its net assets).
Matthew Read is senior analyst at QuotedData