The utility sector has been one of the best performing sectors in the equity capital markets for more than two years. A low interest-rate environment and investor focus on dividends has helped lift most utility stocks during the last several years. In many respects, this has been a case of the rising tide lifting all ships. But, as another cliche goes, it's only when the tide goes out that you see who is swimming naked.
Lost in the noise surrounding the recent passage of the Energy Policy Act of 2005 and concomitant repeal of the Public Utility Holding Company Act (PUHCA) are signals in the market that may indicate a change in how investors are likely to view the sector going forward. The recent strong performance of growth-oriented utilities in the secondary market, the success of ITC Holdings in the new-issue market, and the preference for companies with proactive shareholder-focused initiatives may each hold clues to investor preferences in the future.
The outperformance of the utility sector relative to the overall market that began in June 2004 owes as much to the fundamentals of the capital markets as it does to those of the industry. For example, the median year-over-year earnings growth that the market was expecting in June 2004 for the utility industry was nearly 6 percent-notable for the sector historically, but not as impressive when one considers that the market was expecting 18 percent EPS growth from the S&P 500. Furthermore, many investors were expecting a rising interest-rate environment that would be a difficult backdrop for yield stocks like utilities.
Equity capital markets issues, more than anything else, have had the most influence on the utility sector's outperformance. Beginning in 2004, the equity markets entered a period of remarkably low levels of volatility. In fact, as can be seen in Figure 1, the equity markets entered a period of low volatility not seen since the early 1990s. In an environment of low equity volatility, investors have a difficult time trading stocks to create incremental risk-adjusted return performance in their portfolios.
However, if an investor can borrow cheaply and fixed-income volatilities are low as well, then that investor may feel safe in borrowing with inexpensive capital to purchase high dividend-paying stocks.
As Figure 2 shows, most yield-oriented sectors share a similar trading dynamic, including real-estate investment trusts, master limited partnerships, and utilities. The stock prices of these seemingly unrelated sectors show a high positive correlation to one another (80 to 90 percent) during the June 2004 to June 2005 time period. As long as an investor's cost of borrowing remains low and the risk of being wrong (i.e., low volatilities) is muted, investors, who are able to borrow and invest the proceeds in high-yielding securities, are incented to do so to enhance returns.
Another capital markets phenomenon that helps to explain the recent sector performance is, quite simply, the fact that utilities were under-owned by many large asset managers. Primarily based upon the thesis that interest rates were likely to begin rising in late 2004 and throughout 2005, many sell-side Wall Street analysts had "underweight" or "cautious" ratings on the sector for much of this recent run in utility equities.
And many of the largest mutual funds seemed to agree. In June 2004, when utilities really started to outperform the market, many asset managers were underweighting the sector. Specifically, of the 10 largest common stock mutual funds, utilities comprised, on average, only 3.1 percent of the portfolios. As of June 2005, those same mutual funds, on average, had a 4.7 percent weighting, and those 10 funds alone accounted for more than $600 billion in assets under management. Therefore, last year, simply by increasing the average weighting of utilities in their portfolios, 10 large mutual funds created more than $10 billion of incremental demand for the group. Utilities have outperformed because of market demand for yield, the improved earnings outlook for the quasi-energy plays, and the fact that they were underweighted by large-cap asset managers.
In essence, many issues related to the capital markets conspired to help drive the performance of utilities. An improving financial outlook for the sector with tax relief on dividend-paying stocks and a sustained environment of very low absolute interest rates explains a large part of the sector performance. Evan Silverstein, former head of Silcap LLC sums it up: "Tax law change [on dividends], thirst for yield in an uncertain economy, and record low interest rates led to outperformance." The other reason for the industry's outperformance, he adds, is what experts in the industry call "the commodity kicker."
It is precisely this commodity kicker that makes for lively debate on the root causes for the sector's outperformance. For many, technical issues in the capital markets explain only a portion of the sector's success. Leslie Rich, a senior analyst at Columbia Management, says, "The principal factors of utility outperformance have been the strength of the commodity markets coupled with increasing amounts of unregulated generation driving gross margins higher, and a lackluster broader market forcing investors to seek yield and growth."
Others agree that certain fundamentals are responsible for sector performance. "The supply/demand for power and the pricing outlook is much better, and companies are doing a better job at executing," said an analyst from another large mutual fund. Even the capital expenditure outlook for the group is viewed as a positive. Kathleen Lally, an analyst at Angelo Gordon, points out that the "forecast growth in capital spending has provided investors with a clearer picture of potential growth in earnings for the sector." And this really gets to the "Back-to-Basics" theme that many have focused on.
In late July, ITC Holdings, the first independently owned and operated transmission company in the United States, issued an initial public offering (IPO) for 38 percent of the company. This highly successful landmark transaction reflects both the recent drivers of value in the utility space and quite possibly the future drivers as well. Investors found in ITC much of what they look for in any stock in any sector. These basics of ITC as a stock provide an interesting potential roadmap for utilities as a whole:
1. Simple Business Model/Predictable Growth. Investors are attracted to companies that can grow meaningfully and predictably. All the better if the company can do so in a easy-to-understand business model. For the utility industry, predictability often is easier to convey than for other industries (except in periods of regulatory proceedings), which is important to the perception of the overall utility sector going forward. Kathleen Lally sees a "capital spending picture that expands, not contracts, which should support an earnings-per-share growth picture." But, she adds, "it makes regulatory support very important." This leads to the second factor that investors focused on with respect to the initial public offering of ITC.
2. Single Jurisdiction Regulation. In the case of ITC, dealing with only one regulatory body (the FERC) was viewed by many investors as a positive. And it certainly helped that FERC is viewed as a more constructive regulator than are the states. The market announced loudly in the ITC IPO that it prefers the singular FERC as a regulatory entity to the labyrinth of state rates cases through which an integrated utility must navigate.
3. Leveraged Equity Returns. In many sectors of the equity capital markets, a major investor concern is that companies are over-capitalized. Many notable analysts and strategists are calling for companies to take capital out of their business or increase their leverage to improve returns to common equity holders. In the case of ITC, the capital structure of the operating company is regulated by FERC and is levered to about 40 percent debt. But on top of the operating company is ITC Holdings, which is ultimately levered 70 percent. A skeptic sees a company that is levered at two levels, and this "double leverage" significantly enhances returns and risks to the shareholders.
But given the predictable nature of transmission, investors view the higher financial leverage in ITC as offset by the low level of operational risk. As a stand-alone, very low-risk business, ITC Holdings can support greater amounts of financial leverage than can a business with more operational volatility. Many utilities have low-risk businesses embedded within the larger organization. As was the case with ITC Holdings, some utilities might be able to more efficiently capitalize these lower risk businesses, thereby improving overall returns on shareholders' equity.
4. High Current Return: As previously noted, dividend-paying stocks in general have been notable market outperformers for some time. ITC offered a premium dividend yield to investors (approximately 4.5 percent). At first glance, the attractive dividend yield might appear inconsistent with a predictable growth story, but the market obviously valued the current income. In addition to demonstrating management confidence in the business, dividends are valued by most utility investors for the discipline they force on industry participants. In the eyes of many investors, the utility industry has a less-than-stellar track record of deploying capital. To these investors, a dividend helps guarantee that only the projects with the highest risk-adjusted returns receive funding.
If the sell-off that began in early August continues and some of the technical tailwinds that the sector enjoyed for the last year or so abate, what can corporations do to outperform their peers?
One area where the industry's better performers might excel is finance. Many sectors are viewed by analysts as being overcapitalized-some significantly. But the utility sector is capitalized much more efficiently than most. Could the sector go even further to generate improved returns to equity holders?
Leading utility companies will continue to search through their asset portfolio in search of places where capital is inefficiently deployed. In other words, opportunities might exist to wring more low-cost capital out of the business to retire high-cost capital. It is less about the simple act of increasing leverage at the holding company and more about increasing the efficiency of the capital deployed by the company.
Having said that, increasing leverage at the holding company level also might be an option with the elimination of PUHCA. That capital could be used to boost returns to shareholders by funding capital expenditures or buying back stock. TXU's proactive approach to creating shareholder value has been warmly received on Wall Street. As a company not subject to PUHCA and the limits on leverage it imposed, TXU already was in a position to be more aggressive than most in the utility sector. But now that PUHCA has been repealed, can other utility holding companies follow TXU's lead? State regulation will be an issue for almost every industry participant, but if the sector no longer enjoys the tailwinds that have helped it for over a year, the winners in a capital-intensive industry will include the companies most efficient with their capital.
If the sector does lose its momentum, it will be important for utilities to be viewed as winners. As of August 2005, the standard deviation of the P/E multiples for the companies in the Philadelphia Utility Index (UTY) was 1.83-a rather tight grouping of valuations that is to be expected in the "rising tide lifts all ships" scenario. In 1999, the standard deviation of the P/E multiples for those same companies was twice as high, at 3.6. In other words, the group will see greater differentiation in valuations if the sector begins to lose momentum.
A portfolio manager of one of the largest, most-highly regarded utility funds echoes this view, but also believes that the better companies in the sector will see their valuations rise relative to other utilities, and that they may continue to outperform the market overall. "The fundamentally strong companies could outperform other sectors," she says, "but overall, the group's multiples should spread again to [better] reflect quality or lack thereof." In an environment of PUHCA repeal and the resulting speculation of increasing M&A activity, being on the wrong end of diverging equity valuations has important ramifications.
Can the sector continue to outperform the market? "Higher-growth utilities with a good dividend story can help allay a general portfolio manager's concerns about the direction of the economy [and, thus, performance of the sector]" notes Paul Patterson of Glenrock Associates. Columbia's Leslie Rich sees a reason for cautious optimism: "Earnings growth, dividend growth, share repurchases, M&A activity, and decreasing reserve margins all point to strong fundamentals for the group.
"However," she adds, "outperformance relative to the rest of the market will depend on continued strength of the commodity markets and the pace of growth in other sectors."
The stocks of most utilities have outperformed the broader market for an extended period. While there are several fundamental reasons for this outperformance, some technical causes in the capital markets may prove fleeting. If past is prologue, then the valuation gap between the good companies and the average companies will widen. The winners going forward will look for cues to the themes found in the recent successful transactions in the primary and secondary markets: capital efficiency, leverage, dividend policy, and execution in a "back-to-basics" environment.