Investors seeking a safe haven have often turned to utilities, and this year has proven no exception. In the volatile month of February, the Utilities Select Sector SPDR ended down 2.4%, compared to a 3.8% decline for the S&P 500.
For a window into the sector, we checked in with John Bartlett, 46, a veteran utilities analyst and co-manager of the Reaves Utility Income fund (ticker: UTG). The closed-end fund, which has a four-star rating from Morningstar, is focused on delivering yield and lower-risk returns, a message that may sound appealing to investors who have been whipsawed by the market in recent months.
The fund, which charges annual fees of 1.66%, doesn’t just buy power companies: It broadly defines utilities to include telecommunication and interstate gas properties. Up to a fifth of the fund can be stashed outside the sector, in stocks that generally still fit their lower-risk, strong yield profile—companies such as Union Pacific (UNP), for example. The fund has seen annualized total returns of 11% over the past 10 years, compared with 6.6% for the MSCI World Utilities Index.
Today, Bartlett sees opportunity in areas from wireless providers to railroads. Read on for excerpts of his discussion with Barron’s.
Barron’s: What’s the outlook for utility investing?
Bartlett: Utilities represent a pretty interesting value proposition right now, as a lot of places where people have traditionally reached for yield have struggled, such as master limited partnerships or more exotic parts of the fixed-income market. The outlook for utilities really remains very strong. Most of these companies have the ability to deliver growth around 5% to 7%. They have a dividend yield in the mid-3%. It is pretty easy to see high-single-digit returns out of these companies on the basis of the dividend and the earnings growth.
And utilities could get a boost if market volatility continues.
Everybody has to take their own counsel on what is going to go on with interest rates. We haven’t been able to pierce the 3% number on the 10-year, and what the Fed is trying to solve for is 2% inflation. If they are right and they are successful, then 3% yield would be close to the top on the 10-year. So given where we are in interest rates I’m very comfortable with valuation. If we wind up in a very big trade war that’s obviously going to have deflationary impact on the economy and again people need to draw their own counsel here. But it is not all higher interest rates all the time out there in the stock market. There are plenty of other things to worry about and I think utilities can remain a very safe haven for folks who have a hard time getting to sleep at night.
Telecommunications now falls under your definition of utilities. What happens when the telecom sector is replaced by the communications services sector?
We won’t change how we invest. What is important to us is generating returns that are lower risk in nature, buying stocks that have betas that are below the market. Generally, we are very much focused on income, so dividends are very important to us. Would that render some of those new companies coming into the telecom benchmark ineligible for the fund? Not absolutely, but a lot of the stocks are going to have a pretty high barrier to entry.
You won’t be scooping up Facebook (FB).
That’s right. We have always paid very close attention to media. We have never owned Alphabet (GOOGL), but we have owned a number of the media companies along the way.
Are rising rates a headwind for your fund?
I’ve been at the firm for over 21 years, through a lot of different interest climates. The utility story is the same as it has ever been, and the utility stocks have been pretty orderly with respect to interest rates. There hasn’t been real big overshoot or undershoot at this point. Bottom line, 80% to 90% of a utility’s dividend yield is explained by the yield on the 10-year Treasury. Volatility of interest rates will translate into volatility for utilities.
That said, we’ve always felt that investors are going to be better served in utilities than they are in bonds. The reason for that is growth and the ability to grow the coupon very consistently over time, and to do so without having to rely on the business cycle. The total-return correlation between the utility and the bond index isn’t perfect because utilities have the ability to raise their earnings and their dividends over time. If over the medium-term, you have a modest increase in interest rates, your only defense in any kind of income-generating security is the ability to grow. We think that utilities have been very dependable and continue to be so.
Tell me about Comcast (CMCSA). Some might be surprised to see it as a top holding in a utility fund.
Technically, we lost our shot at cable companies being an actual regulated utility [as courts and the government have categorized the two separately]. Comcast is very stable, and over time, the broadband business for Comcast is very, very attractive. Lower-quality video revenue will continue to be traded for high-margin, nondiscretionary broadband revenues. The durability of this growing cash-flow stream should continue to positively influence valuations over time.
Comcast has struggled this year because people’s perception of M&A has weighed on the stock a lot. [Some have worried it will get in a bidding war over assets.] But Comcast has consistently grown the earnings and cash flow from its cable franchise. Frankly, we think that the stock market has probably overdone concerns around M&A at this point.
You also own several wireless carriers.
The wireless market is brutal and the best positioned company is T-Mobile US (TMUS); it’s certainly the fiercest competitor out there. That said, people’s concerns on wireless competition are probably overdone. Verizon Communications (VZ) represents a very good value at this price. It’s one of the largest cash taxpayers in the country, and the stock is selling about where it was before the discussion on tax reform.
Both Verizon and AT&T (T) have a big dividend; their ability to raise that dividend is fairly modest. But both stocks are cheap and reasonably priced, with a big dividend yield. The yield helps us paddle the canoe, as it were, for the fund, and we look for a little more growth from other things.
Let’s talk about some actual utilities in your top holdings.
NextEra Energy (NEE) is really the premier utility in America. It has a wonderful track record of continually cutting costs and improving the reliability of its system. Plus, it has a very strong regulatory relationship with the Florida Public Service Commission. That constructive relationship has yielded really great results for all stakeholders involved, be it rate payers or shareholders. It has a great system and a great management team that’s just on the Florida Power & Light side.
It also owns a subsidiary, NextEra Energy Resources—the largest owner of wind power in America—and it’s developed a good bit of solar too. It has been a wonderful entrepreneurial story of that company and it continues to be a very solid performer. So you have really what I would call an ESG [investing according to environmental, social, and governance factors] dream, because you have a utility that continues to cut its carbon emissions and continues to improve its efficiency, and on top of that you have really the leading developer of renewable power in America.