With the likes of the US Federal Reserve and the Bank of England expected to raise rates over the coming year or so, the large majority of industry experts have warned that utility companies such as electricity, water and gas suppliers will underperform due to their defensive, “bond-proxy” characteristics.However Smith, manager of the Premier Global Power and Water fund, says that view is very ill-informed.
“It is complete and utter nonsense, which seems to be spread around by non-specialist investment managers, that utilities somehow equal bonds,” Smith said.
“I see that a lot of managers are avoiding utilities and looking for other companies in preparation for rising interest rates. However, utilities are actually less-sensitive to interest rates than the large majority of other sectors.”
A number of leading fund managers, such as Artemis’ Jacob de Tusch-Lec, have warned investors about the outlook for defensive sectors, like utilities.
The sector’s bears say the outperformance of utilities since the financial crisis has mainly been brought about by the ultra-low interest rate environment, as investors have been forced into the equity market but at the same time haven’t wanted to move too high up the risk spectrum.
Performance of indices over 5yrs
Source: FE Analytics
On the other hand, with economies improving and interest rates set to rise either at the back end of 2014 or in 2015, they say the sector will be hit hardest due to its regulated income streams, poor growth outlook and stagnant dividend potential.
They therefore argue investors should be turning to more economically-sensitive areas of the market.
Smith says there are a number of huge misconceptions there, however.
“Companies with the value of their earnings streams furthest into the future – the market calls these ‘growth companies’ – should in theory be more sensitive to interest rate movements,” he explained.
“This is just the same as seen in the bond market, with longer duration bonds being seen as riskier than shorter duration. Utilities, with their higher near-term dividend streams, are shorter than average duration and hence should be less sensitive than average to movements in interest rates.”
Smith also notes that companies within the sector tend to have relatively high gearing and higher interest rates would usually lead to higher finance costs, and therefore lower profits.
However, the fact that utilities are heavily regulated is a massive help.
The manager points out that during every regulatory reset, allowed returns are adjusted to take into account movements in interest rates which means that higher rates are passed on to customers over time in the form of higher tariffs; an advantage other sectors don’t have.
He also says that because rate rises are usually implemented due to inflation, utilities’ regulated income stream, once again, comes in handy.
“Regulated utilities in the UK are allowed a return on a Regulated Asset Base or ‘RAB’, otherwise known as the Regulated Asset Value or ‘RAV’,” Smith explained.
“This represents the total value of their assets subject to regulation. Crucially, the RAB, or RAV, is indexed meaning that the returns allowed on it are directly linked to inflation.”
“If interest rates are increasing as a result of higher inflation, then utilities’ returns should be automatically increasing in nominal terms at the same time, offsetting the valuation impact of higher rates.”
Smith’s final point is that it is dangerous to group all utility companies into one basket.
“The theory that the share prices of utilities will fall should interest rates increase is predicated on utility company earnings being fixed, like the coupons of a bond,” he said.
“However, this simply isn’t true. Utility companies are just like other companies, they invest, they make savings, they get taken over, they make acquisitions, they create value and they lose value. Their earnings streams are variable.”
“Long-term performance is a factor of strong management, sound investment and capital discipline and not just interest rates.”
However, Smith says all these misconceptions have enabled his fund to outperform recently.
According to FE Analytics, his £17.7m Premier Global Power and Water fund has been the best performing portfolio in the IMA Global Equity Income sector over one year with returns of 13.61 per cent, beating its benchmark – the FTSE World Utilities Index – by close to 10 percentage points.
Performance of fund vs sector and index over 1yr
Source: FE Analytics
The fund has also topped the sector, and beaten its benchmark, in 2014.
“The reason why the sector has done well is really down to the attitudes mentioned - a lot of investors had been avoiding the sector and it meant that they have been quite cheap and offered a lot of value,” Smith said.
Smith joined Claire Long as manager of Premier Global Power and Water in June 2012.
Our data shows the fund has returned 37.34 per cent over time while the sector and index have returned 34.8 per cent and 21.26 per cent, respectively.
Performance of fund vs sector and index since June 2012
Source: FE Analytics
Smith, who also manages the closed-ended Premier Energy & Water Trust, currently holds 50 per cent of his fund in electricity companies, 30 per cent in multi-utilities and the rest spread across water and waste, gas and renewable energy.
He has a high-weighting towards emerging markets as well, with China making up his largest regional weighting.
Premier Global Power & Water fund has a yield of 4.65 per cent and has an ongoing charges figure (OCF) of 1.7 per cent.
