on American Centurys Value Investment Team
Sponsored Content American Century Investments
June 1, 2010
In its quest to provide investors with higher levels of dividend income, American Century® Equity Income often has significant investments in utility stocks. That was the case at the end of the first quarter of 2010, when the portfolio carried an overweight position in the sector. Senior Investment Analyst Philip Sundell, CFA, follows utilities for American Century Investments’ value investment teams. We recently spoke with Sundell to get his views on the state of the utilities sector, the types of utility stocks Equity Income favors, the sector’s recent performance, and the risks and uncertainties that utilities could face in the years ahead.
Q. Going into the second quarter of 2010, Equity Income had a significant overweight in utilities relative to its benchmark, the Russell 3000 Value Index (10.65% for the portfolio versus 6.25% for the index). What’s behind your confidence and comfort level in the overweight?
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Sundell: Equity Income’s highest-confidence investments in the sector are in natural gas local distribution companies (LDCs), and these stocks account for the majority of the portfolio’s overweight position. LDCs are companies involved in the delivery of natural gas to residential consumers and industrial consumers within a specific geographical area. They typically transport natural gas from delivery points along interstate and intrastate pipelines through thousands of miles of small-diameter distribution pipe.
These are appealing utility business models to conservative equity investors. They tend to have stable earnings and stronger balance sheets. As pure natural gas distributors, they’re not involved in exploration and don’t operate generation facilities, so less of their cash flow must be earmarked for capital expenditures on plant and equipment. As a result, this subset of utilities has tended to have higher dividend yields that are internally funded, which we believe has made them more secure and sustainable. We prefer to invest in regulated utilities—whether they’re natural gas or electric—because their earnings and cash flows are more predictable.
WGL Holdings, Inc., is emblematic of the type of utilities Equity Income targets. This is a public utility holding company whose subsidiary, Washington Gas, serves the Washington, D.C., metropolitan area and portions of Maryland and Virginia. The area is the fourth largest regional economy in the nation, and Washington Gas continues to capture more than 90% of new residential construction. Dividend income is a top priority for Equity Income, and this has been a reliable dividend-payer. With a 158-year history of consecutive dividend payments—and a record of 34 consecutive annual dividend increases—WGL Holdings has one of the longest dividend-payment records on the New York Stock Exchange.
Q. Could you put the recent performance of the utilities sector in perspective? Within the Russell 3000 Value Index, the utilities sector was up 10.22% in 2009 versus a 19.79% gain for the index. During the first quarter of 2010, utilities were down -2.80%. What factors accounted for utilities lagging in 2009 and their negative returns for the first quarter of 2010?
Sundell: We can get more perspective on the recent performance of the utilities sector by
going back a little further in time. As history has shown, utility stocks tend to perform relatively well during recessions because investors seek stocks of companies with more reliable earnings and cash flows in a slow economy. In addition, interest rates generally decline in a recession as the Federal Reserve (the Fed) tries to stimulate consumer and business spending. When rates on certificates of deposit or bonds fall, the yields associated with utility stocks look better by comparison.
That scenario played out as the financial crisis roiled the markets in 2007 and 2008. Utilities outperformed the broad market in both years as nervous investors sought safety in the form of predictable earnings and dividend payments and searched for higher yields in the midst of Fed rate cuts. In 2007, the utilities sector in the Russell 3000 Value Index was up 10.78%, versus a -1.01% return for the index. The following year, while the Russell 3000 Value Index dropped -36.25%, utilities held up well in relative terms, declining -25.26%.
The sector’s relative underperformance in 2009 and the first quarter of 2010 are not surprising. The period saw stocks stage an almost unprecedented turnaround as credit markets thawed and the economy showed signs of recovery. Investors shifted into riskier assets, and many of the largest gains have belonged to lower-quality businesses that fared the worst during the financial meltdown. Given the slow and steady nature of their earnings, utilities typically lag during market surges—although they still posted a double-digit gain in 2009.
Some of the utilities sector’s recent underperformance can also be attributed to lower commodity prices—especially for natural gas, which dictates prices for non-regulated utilities and independent power producers that sell wholesale power to the market. Their profits have been further pressured by a significant decline in the demand for electricity due to slowing industrial activity and households watching their utility spending.
During the first quarter, utilities represented a rich source of dividends for equity investors seeking income, as well as fixed-income investors in search of higher yields. As of March 31, the S&P 500 utilities sector had a current yield of 4.47%, compared to 1.87% for the broad market benchmark and 3.83% for 10-year Treasury bonds.
Q. What are some of the key changes that have been occurring in the utilities sector during the past decade or so? There was a time when utilities were considered the quintessential “widow and orphan” stocks. Their profitability was highly regulated and they paid out most of their cash flow in dividends. Is this still largely the case or are things different today?
Sundell: I think we can remove the “widow and orphan” label from many of these stocks. Since the early 2000s, the face of this industry has been altered, and what may once have been a “sleepy” sector for investors now carries a higher level of risk because the fundamentals have changed.
The increased risk has been most prevalent among electric utilities, and it stems largely from capital spending requirements that have grown dramatically. A generation ago, capital spending by most utilities was relatively stable. In fact, some might say utility spending didn’t keep up with infrastructure needs—witness the “brownouts” in the ‘70s and ‘80s. Things began to change around the middle of this decade when electric utilities were forced to invest at historic levels to expand and modernize transmission grids (the high voltage networks that transport large volumes of energy from production facilities to urban areas), build new power generation plants, increase environmental spending, and invest in renewable energy sources. Between 2004 and 2008, capital expenditures basically doubled for public utilities, going from $40 billion to $80 billion.
The higher levels of spending have significantly reduced the free cash flow of the industry. That’s led some companies to issue equity—diluting current shareholders in the process—to support both high dividend payouts and capital spending requirements. Others have had to cut their dividends to protect their balance sheets.
We think that much-higher levels of capital spending are going be a potential strain on utilities’ balance sheets for years to come as they expand and modernize their asset bases to keep up with end-user demand and meet increasing industry regulation. Toward that end, more than half of the electricity generated in the United States comes from coal, which, because of its low cost and abundance, will continue to be the dominant fuel used in electric power production. To assuage environmental concerns, however, operators of coal-fueled power plants are going to have to invest heavily in technology to eliminate the pollutants released when coal is burned and take steps to significantly increase their fuel efficiency.
Q. You’re the chief analyst for the value team assigned to the utilities sector. What are the challenges in researching these types of companies? Do you use additional or different price/valuation metrics for utilities? What are the top questions you ask utilities’ managements?
Sundell: Over the long term, returns for regulated utilities tend to fall in a narrow band.
On a quarter-to-quarter basis, though, their returns can vary greatly due to factors like the weather—warmer winter months or cooler summers that reduce power demand, or dry seasons resulting in insufficient river flows or reservoir levels for hydroelectric plants—or events like unexpected plant outages. To ensure we’re not swayed by short-term returns, we focus on “normalized earnings,” meaning that we adjust those figures for both the cyclical ups and downs as well as the one-off events utilities experience.
We spend a lot of time with managements on the regulatory environment they face as we try to anticipate regulatory changes that could affect earnings and gauge the potential impact of rate cases they may be preparing to file. Out of this conversation we get an understanding of a utility’s “regulatory lag,” the difference between the returns on equity authorized by regulatory commissions and the actual returns the utility is experiencing. If those returns are meaningfully lower, we want to understand what’s behind the shortfall and determine whether the utility can close the gap.
Next, we want to know plans for future capital spending and how the utility intends to fund projects that could last several years. We’re hesitant to invest in companies whose projects seem unrealistic in terms of size or expense, or require taking on significant new debt.
Overall, our fundamental analysis and valuation work is designed to lead us to utilities with above-average balance sheets and reasonable capital spending plans, that are in stable or improving regulatory environments, and that are selling at a discount because they are temporarily under-earning.
I think one mistake utility analysts can make is focusing on the growth of a utility’s rate base (the value of a regulated public utility on which the company is allowed to earn a particular rate of return), as opposed to how the spending that’s fueling rate-base growth may be reshaping the balance sheet. We’d rather invest in a utility with a strong balance sheet that’s experiencing modest growth and sidestep one that’s growing rapidly, but funding that growth by issuing large amounts of debt or equity.
Q. What are the greatest risks or uncertainties that the utilities sector faces going forward?
Sundell: A major uncertainty for the industry is whether—or how much—future regulations will impact utilities’ capital spending and free cash flow. For example, we could see a national Renewable Portfolio Standard (RPS)—a government regulation specifying that electric utilities generate a specified fraction of their electricity from renewable or alternative energy sources, such as wind or solar power. If requirements for renewable power increase substantially, many utilities could face funding pressures. Similarly, future environmental regulations aimed at limiting carbon emissions and other pollutants would almost certainly translate into increased operating costs.
Higher operating expenses—and higher utility bills—could also arrive in the form of increasing prices for coal and natural gas. Over the past few years, many utilities ratcheted up their capital spending, but rate-payers’ bills stayed flat due to tumbling natural gas prices. In a situation where rate bases and fuel costs are rising simultaneously, regulatory commissions, which have a political component to them, could take the side of beleaguered consumers and limit the costs that utilities could recover.
We think the scheduled increase in dividend income tax rates—if it occurs—will probably have a limited impact on many investors in utilities. As you may recall, in 2003, Congress temporarily set the tax rates for dividends and capital gains at 15%. That tax rate reduction is set to expire on December 31. Absent Congressional action, the maximum tax rate on dividend income will rise in 2011 to 39.6%.
The current spread between the dividend yield on utilities and the yield on 10-year Treasury bonds may be a sign that the market is already pricing in some change in the tax laws. Even if the tax rate changes, however, a broad swath of investors would be unaffected, including those who own utilities in tax-advantaged investments such as 401(k) plans, 403(b) plans and Individual Retirement Accounts, as well as many institutional investors. In addition, if tax rates go up across the board, the tax on dividend income may retain its advantage relative to other taxes on income.
At the end of the day, investors in utilities need to realize that they’re dealing with changing companies in a changing industry—many of these businesses could face new operational and financial pressures in the years to come. That places an even greater premium on effective stock selection, which we think plays to our strength as bottom-up investors. Success is going to depend on really getting both the fundamental and financial analysis right.
The opinions expressed are those of Philip Sundell and are no guarantee of the future performance of
any American Century portfolio. Statements regarding specific holdings represent personal views and
compensation has not been received in connection with such views. This information is not intended
as investment advice.
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