Investment trust opinion: Powering returns

Carthew

Financial advisers often access the utilities equity sector for the attractive dividends on offer and the companies’ defensive nature with their relatively stable and predictable cashflows – an attraction for many investors looking to make money whichever direction the economy takes. 

After utilities’ strong performance in 2014, led by the US with its benign interest rate outlook and modest growth, this year’s performance has been more difficult. This is likely as a result of fear about interest rate rises in both the US and the UK. 

As utilities tend to carry more debt than other companies, a privilege allowed by their strong cashflows, they are often more sensitive to rising interest rates, but we would argue this impact is mostly short term.

A simplistic view is that higher interest rates tend to depress the earnings of companies that borrow a lot of money and increase the discount rate used by the market to work out the value of their future earnings, both depressing valuations. Therefore, rate rise fear can cause volatility in utility companies’ share prices. 

Taking a medium to long-term view, utilities are largely regulated businesses whose pricing is periodically reset though tariff reviews. So, over the long term, they can offset the impact of rising rates to earn a real rate of return. Similarly, as the UK moves back into inflation – with rising rates normally meaning more inflation – in such an environment utilities are often allowed to increase prices. 

As the regulatory environment has a large impact upon utility companies passing on cost increases to the end customer, it is clear why stock selection is key when looking globally for opportunities. Fund managers picking these companies need to have a strong understanding of the regulatory environment in which they operate and make a judgement call on their ability to raise prices. 

utilities

A potential headwind to the sector has been the Department of Energy & Climate Change’s decision to phase out the renewable subsidy regime early. The DECC took the decision to close the Renewable Obligation subsidy for onshore wind farms a year earlier than planned as part of the Government’s overall plans to reduce the renewable energy industry’s reliance on subsidies.

The DECC will replace it with a new scheme, which it is thought might lead to lower returns. However, asset managers note that grace periods have been introduced for projects where planning permission has already been approved. 

The investment trusts offering access to the utilities sector – Premier Energy & Water (PEW), Utilico Emerging Markets and Ecofin Power & Water Opportunities – are split capital funds, which means that they can generate an enhanced income for ordinary shareholders from the gearing achieved through this structure. 

Furthermore, many of the underlying companies are attractive too, with US utilities showing 10 per cent dividend growth for the next few years, looking at the numbers used by PEW. 

Looking specifically at PEW, since a change of strategy in 2012 the trust has increased its exposure to the UK. While the recent weakness among UK stocks in response to government policy changes must be borne in mind, the income offered by the UK utilities sector in general is attractive with the current yield on the FTSE All-Share Utilities index, at 5.2 per cent. The recent market movements have presented the opportunity to add some new holdings at attractive levels. 

While the UK markets are attractive, looking globally at utilities valuations, they are cheap relative to their history.

The FTSE All-Share Utilities index is trading on a price-to-earnings ratio of 13.9 times for 2015, below its five-year average of 14.9. Emerging market utilities as a whole are cheaper, with the MSCI Emerging Market Utilities index trading on 10.2 times for 2015 earnings, compared to a five-year average of 12.1.

Specifically, PEW has been finding increasing value in emerging markets, which is enhanced by stronger expected dividend growth. The projected dividend growth on the MSCI Emerging Market Utilities Index is 5.2 per cent over 2015, compared to 2.7 per cent for the wider FTSE All World Utilities Index.

This has had a knock-on effect on the dividend yields offered by investment trusts in this area, which are attractive, with PEW’s historic yield now over 9 per cent and Ecofin nearly 6 per cent.

James Carthew is research director at QuotedData.