The stereotypical view of utilities is of a fairly homogenous group of companies providing similar services and with similar investment characteristics. This stereotype is not the reality. Increasingly they are a heterogeneous group of corporations offering myriad opportunities to their investors.

In general the nature of utilities’ business makes many relatively immune to short-term economic cycles. Many are cash-generative firms and the cash generation potential of many of them is visible well into the future.

Individual vs indices performance

Yet discerning between companies, using a hedge fund’s flexibility, is of key importance. In 2006 the performance of the median constituent of the DJ EuroStoxx Utilities Index was 28%. However, individual stock performance in the sector index last year ranged from -22% to 79%. In 2005 share price performance of the index’s component firms ranged from -20% to 150% and year-to-date in 2007 the outliers are -19% for one stock, 138% for the best performing.

In addition to this divergence, what actually comprises the category of ‘corporate utilities’ differs widely between countries. In the UK one typically thinks of electricity or gas. In France one thinks more of water, where private providers haveserved communities for many decades, while electricity and gas suppliers remained state-owned. On the continent generally, waste management also sits in the ‘utilities’ basket.

So, given all these differences, what unites utilities? They all enjoy long-term contracts, a characteristic one also finds in power firms as well as in train franchises and bus groups, airports or toll road businesses in Europe or the US. As a group they have a low correlation with equity markets, and a high dividend yield, equating to a sector average yield of 5%. Yet the themes driving the utilities sector are as disparate as the companies themselves.

The outsourcing of utilities’ functions from government to the private sector is one clear theme still playing itself out globally. However, beneath the commonality there are regional differences – globally less than 10% of water distribution is in private hands, for example, but it is 100% in the UK. In France around 80% of water distribution is run by private enterprise and in Europe it is around 25% overall.

This outsourcing is being driven by the increasing sophistication of utilities, and by many governments and local authorities not being prepared to make the capital expenditure necessary to comply with ever-tighter environmental standards.

Another undercurrent present among utilities is that of consolidation. In the past, international distribution was near impossible. However, as more pipelines and cross-border powerlines have been built, the businesses using them are also increasingly thinking, and trading, globally.

With this in mind we have already witnessed Spain’s Iberdrola acquiring Scottish Power in April, for example. However, we believe the sector’s M&A activity is still nascent.

Environmental concerns form another theme driving the structural evolution of utilities, and forcing both further outsourcing and capital expenditure. Twenty-five years ago, for example, there were 10 criteria for deeming water ‘drinkable’. Now there are more than 100. Quality improvements have entailed costs of compliance, made in large part by the private sector.
Arbitrage opportunities in energy

On the pollution front, investment arbitrage opportunities have arisen with the introduction of the carbon credit trading market in Europe under the aegis of the Kyoto Protocol, which has seen upward re-ratings of shares of some utilities engaged in less environmentally damaging energy production – nuclear or hydro power as opposed to coal-fired power, for example. Having coal at all-time high prices has assisted this re-rating trend.

On the pollution front, investment arbitrage opportunities have arisen with the introduction of the carbon credit trading market in Europe under the aegis of the Kyoto Protocol, which has seen upward re-ratings of shares of some utilities engaged in less environmentally damaging energy production – nuclear or hydro power as opposed to coal-fired power, for example. Having coal at all-time high prices has assisted this re-rating trend.

Renewable energy, including wind, solar and hydro, is a further area some of the major utilities are getting involved in. Thus far Spain and Germany stand out, having offered tax incentives for developing wind-power generation. Several wind-generation companies’ IPOs have already occurred, and investors are attaching high multiples to the shares of utilities engaged in wind power. EDP and Iberdrola, the latter with plans to IPO its clean energy business, Iberdrola Renovables, present themselves as leaders in exploiting this alternative energy source.

A further current in the evolution of utility markets is that of liberalisation, a process that has been locally controlled, but which started centrally in Brussels in 1999. As a result, in theory any electricity player in Europe can bid for a contract anywhere in Europe and any firm could, again in theory, bid for any customer in Europe. While the UK and Germany opened their markets to foreign firms in one fell swoop in 1999, France only implemented it in 2007, opening its residential market to competition. EDF in France now sells electricity in London, and earlier this year we witnessed political discord about the pipeline delivery of gas from Russia to the Ukraine.

Interestingly, where utilities’ capital expenditure is linked to wider distribution, such as pipelines or power cables, analysts may now see this as positive, whereas in the past its cost was viewed more negatively. (Commentators expect €500 billion to be invested in power production by 2015, given the need for new generation and transmission and capacity across Europe and the US).

While cross-border sales and consolidation clearly represents an internationalisation of utilities, the sector demands of its analysts and investors an intricate understanding of local variations on the themes, and concomitant careful stock selection. Know how Ford works and one can understand more or less how Fiat operates, but understanding what drives a utility in Texas does not automatically mean one knows the drivers of one in New Jersey, let alone competitors in Italy and Spain.

Some investors may be hesitant to invest in utilities due to a perceived regulatory risk: the danger that unexpected political/regulatory decisions could adversely affect their holdings.

However, nearly two thirds of the universe is not regulated, and one finds business models such as Centrica’s in the UK, for example, that are widely unregulated. While regulated businesses such as firms transporting electricity may not be as geared for high-growth, the regulation can be necessary, as such business is by nature in a monopolistic situation, locally or nationally.

While utilities are not the stocks that do best in cyclical rallies, they are effective defensive plays. And for those who equate ‘defensive’ with ‘dull,’ and view utilities as a bond-proxy, it is worth noting that utilities’ average volatility is close to the market’s as a whole – however an annualised sector volatility of 15%-16% can be reduced to 4%-6% in the Utilities & Visibility Fund given its hedge fund nature.

While the presence of regulators affords investors certainty, and comfort that a framework in place can be enforced, non-regulated firms are typically more oriented towards higher growth, providing an interesting spread of investment opportunities.

Jean-Hugues de Lamaze set up the Utilities and Visibility Fund with Sebastian Letellier