Premier Energy and Water Trust

Premier’s James Smith – no relation – is a two-decade utilities veteran and chafes against the perception of these businesses as ex-growth, underperforming and full of political risk.

“Investors should also remember that utilities remains a strategically important sector for the economy and if you scare capital away too much, we end up with blackouts.”

James Smith

To put some figures behind its actual profile, he highlights that the FTSE Utilities sector has produced a total return of slightly more than 386% in the decade to end May, more than doubling the 164% from the FTSE All Share. Smith says the myth about underperforming utilities comes from headlines about government interference in what remains a largely regulated sector, where he admits political point scoring can occur. “That said, regulated entities have major advantages in that they can pass through inflation to customers, whereas most other businesses will see their profits squeezed,” he adds. “This has meant utilities have remained attractive for sovereign buyers on an opportunity cost basis – a Canadian pension fund for example can buy local debt yielding somewhere around 2% or a UK regulated water company with a 5% inflation-linked yield. “Many retail investors however still assume utilities are low risk and must therefore be low return but this is not the case. In the UK for example, utilities are always growing their asset base, which means more potential for rising earnings and profits.”Playing the power themeSmith outlines a compelling case for utility outperformance, with their regulated status – requiring business plans stretching out into the future – mitigating the impact of factors such as commodity prices, demand, competition, interest rates and inflation. Demand for power, water and gas is also increasing globally, particularly in developing markets. He joined Premier last June after 14 years at Utilico – where he specialised in the global utilities, transportation infrastructure and renewable energy sectors – to head up the Energy and Water investment trust and the Global Power and Water fund. On his arrival, the open-ended vehicle was skewed towards technology businesses in the sector, but Smith has subsequently moved the focus towards the regulated utility end as well as introducing an income focus. As a result, the portfolio underwent almost 100% stock turnover and also moved sectors this year, from Specialist to Global Equity Income “The technology side is not my area of expertise and we also feel there are better ways of playing the power theme,” adds Smith. “Our view is that it is usually better to own the wind farms than the wind turbine suppliers – if you look at airports as a comparison for example, the vast majority have outperformed the airlines that fly in and out of them.” China is something of an exception to this broad skew away from water and energy technology, with the country exemplifying many of the major scarcity and pollution themes. With its water for example, most of the country’s resources are in the south and massive desalination plants are required to supply the northern provinces. Smith says it is still difficult to invest in attractive businesses in these areas but highlights China Everbright International as one holding involved in the sewage treatment and water recycling industry. Since the change in strategy, the fund has moved to a quarterly dividend policy and is yielding around 4%, with Premier now taking fees from capital rather than income.Utilities and incomeLooking at performance from 1 July to end May, Smith and co-manager Claire Burgess have doubled the return from the MSCI World Utilities index, and he is confident of generating more than enough capital growth to offset fees. To that end, around a quarter of the portfolio remains dedicated to growth names. Highlighting the suitability of utilities for an income mandate, the sector has almost doubled the dividend growth rate of the FTSE All Share over the last 10 years. “With the five-year regulated periods for utility companies now increasing to eight years, these businesses have far greater visibility than most corporates and can set dividend policies accordingly,” adds Smith. “Severn Trent for example has an RPI plus 3% dividend policy while National Grid, with its most recent regulatory review stretching to 2021, can adopt much higher payouts than Vodafone, which cannot know how its industry will develop from year to year.” With these various advantages, utilities trade at a premium to the market – 13.8 times against 11.3 for the All Share – but Smith says this could justifiably be much higher. When analysing utilities compared with other equities, he says the regulatory situation has to be a concern as this is a more political sector than most. “In Germany for example, the government has done considerable damage to its incumbent utilities by pushing through a massive renewable energy requirement and this is clearly an area where political intervention can potentially damage returns,” adds the manager. “But investors should also remember that utilities remains a strategically important sector for the economy and if you scare capital away too much, we end up with blackouts.”Regulated and unregulatedWhile the portfolio is currently around half in electricity stocks, Smith does not separate companies into water or power, primarily viewing holdings through the regulated or unregulated lens. “If you look at an electricity generation company for example, that business is in an extremely competitive marketplace and exposed to rising carbon, gas and coal prices,” he adds. “An electricity distributor like National Grid on the other hand is wholly regulated for eight-year periods, allowing the management to set things like capex spending out in advance.” Global exposure While the portfolio is geographically diversified, with more than a third in emerging markets, Smith says it is increasingly possible to look at utilities as a genuinely global industry, with many countries adopting the UK’s regulated model. US exposure looks something of an anomaly at just over 4% but the manager highlights the fact many of these businesses are wellknown and understood so it is difficult to extract any outperformance – in contrast to opportunities in China for example. While the team largely takes a bottom-up approach, Smith says China is a clear example of a country with a dynamic utility sector, which justifies the portfolio’s 20% position. Favoured companies include China Suntien Green Energy, which has already almost doubled Smith’s money since investing late last year – highlighting the huge potential growth in these industries. “This business is split between windfarm and gas transmission operations, which both have good growth dynamics,” adds Smith. “On the windfarm side, China’s pollution issues are well known with so much of its power coal-fired and the government has introduced several measures to incentivise more renewable energy use. Meanwhile, gas transmission is also a huge growth business, with China only using around 30-40% more gas than the UK, which is negligible considering the size differential. Moving from coal to gas is a simple way of making an economy greener and China is currently building infrastructure to bring the commodity in either via land or sea.” Most of the fund’s Chinese positions – which also include China Power International and China Resources Power – have produced strong returns in recent months. Smith notes the former as particularly strong as a result of record high levels of hydropower generation, with the peak season for this approaching. “It should also coincide with further positive news from the Chinese government regarding reform to the hydropower tariff,” adds the manager.Plugging into the gridLooking closer to home, Smith notes names such as National Grid and Centrica among his largest holdings, once again pointing to their index-linked yield and visibility stretching years into the future. “As part of National Grid’s latest regulatory review, it confirmed that electricity prices will increase 30% over the period to 2021,” he adds. “Before this, a few brokers and journalists were assuming the company would have to cut its dividend, forcing the share price down, but we never felt this would come through as the balance sheet is not stretched.” Considering the team runs an investment trust in this space, rival closed-ended offering Ecofin is a surprise inclusion in the fund’s largest positions. They own convertible bonds in the trust, which Smith says are trading just over par and are currently five times covered by assets. “The conversion price is around the vehicle’s NAV and we feel this gives us good exposure to the sector in an advantageous capital structure, with potential for some decent upside,” he adds. On the macro front, Smith says there are obvious issues for sectors such as power generation with austerity policies in place, as you have a fixed amount of capacity chasing a market declining in size. Overall however, he is confident in utility growth in countries such as China, despite ongoing concerns about slowing economies. “Our view is that areas like renewables and waste recycling are now effectively counter cyclical given the pollution situation,” adds Smith. “During the country’s investment binge over recent years on fixed assets like toll roads and airports, the one area that missed out has been updating the coal-fired power stations. In light of the pollution situation, we feel China will continue spending on this area whatever its GDP level.”