Once upon a time, utility companies were the go-to investments among advisors who wanted something "safe and reliable" for widows and orphans. Utilities were regulated and generated a steady stream of dividend income, even if growth was unexciting. Then came deregulation and a difficult period of adjustment. Now, well-managed utilities can spark competitive returns as well as dividends.
"What we have now is a group of companies that have split into two different segments: one, the companies that are still primarily regulated and are focused on the distribution business, and [two], the companies that have a mix of regulated and non-regulated businesses and have a focus on deregulated generation. The deregulated generation companies today are performing very differently from the more traditional utilities," says Judith Saryan, portfolio manager of the $911 million Eaton Vance Utilities Fund (EVTMX). Saryan has been following the utilities sector "on and off for over 25 years," so she's had the chance to closely watch the group evolve. That experience has helped Saryan produce returns that have consistently outperformed the utility group's average, generating a five-star rating from Morningstar and a four-star ranking from Standard & Poor's.
According to S&P, the fund returned an annualized 6.08% for the five years ended September 30 versus an annual (-0.36%) for the S&P Utilities Sector Index–and a negative (-1.49%) annually for the S&P 500. The performance trend seems to be strengthening, with the fund earning 29.45% annually for three years, versus 26.71% for the S&P Utilities Sector Index; and a one-year total return of 40.42% versus 38.67% for the utilities index, according to S&P.
How have utilities stocks changed from when my grandparents might have owned them? Utility stocks have changed quite a bit in the last 25 years. The main difference is that several years ago the companies were primarily regulated and that included telephone companies as well as electrics, but they were all regulated so the returns were fairly consistent, and growth rates were very low. Returns were quite consistent across the utility universe. That changed dramatically about seven years ago when the electric utility industry became deregulated.
What's your investment process for the fund? At Eaton Vance we're fundamentally driven in our stock selection. We analyze our industries very closely, and then we drill down to the individual companies and analyze each company to see what are the main fundamental drivers of that company. We look for companies that have strong management teams and business franchises that can grow their cash-flow generation and their dividend at an above-average rate. These are the primary characteristics. Then we look for companies that are selling at discount valuations relative to the utilities group.
So there's a value edge to it? There's definitely a value edge. We look at relative value versus the group, versus the overall industries, and the S&P 500. We are internationally focused so we compare the relative valuation versus comparable companies overseas. We are diversified across all the utility subsectors, including electrics, telephone, water utilities, gas utilities, and we're diversified geographically. We think that by doing this we can reduce risk and that's proven to be the case. We have had very strong performance, and when you look at our risk characteristics–beta, standard deviation of return, and most other types of risk ratings–we always rank very well on the low side of the risk spectrum. So strong returns and low risk–that's what we're trying to achieve. I think the diversification has really helped in that regard. We have a strong sell discipline, [with] a lot of the same approaches to our sell discipline as to our buy discipline. It's very fundamentally oriented: If a company's fundamentals change, we'll quickly get out of the name, go to the sidelines, and re-analyze the situation.
Will you talk about your largest holdings? If you look at the last quarter, we've had very strong performance in some of these names. TXU (TXU) and Exelon (EXC), are two that come to mind; a third very large holding is Edison International (EIX). All of these companies have benefited from higher commodities prices. They all have deregulated generation. That's what we look for because we would expect to see more growth coming out of these companies–more earnings growth, more cash-flow growth–and so far that's been the case. The price of power is very much tied to the price of natural gas, and natural gas has been moving upward pretty dramatically. That has had a big impact on the performance of those stocks and performance of the fund. In the last few days [the interview took place Oct. 6], there has been a lot of volatility in the commodity markets; these stocks have also been very volatile on the downside. Natural gas prices had moved up so rapidly, the utility group had moved up very rapidly, and now the market is digesting that. We still believe there is going to be upward pressure on commodity prices. We're not trying to forecast a specific commodity price but we think it's going to be higher than most other energy analysts are predicting.
