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Utilities  Download PDF
March 31, 2008
We are pleased to share with you our review of the utilities sector as of March 31, 2008. In the first quarter, the S&P 1500 Supercomposite Utilities Index had a total return of –9.8%, compared with –9.5% for the S&P 500 Index
Investment Review
The traditionally defensive characteristics associated with utility stocks did not spare them the volatility and negative returns seen across equity markets in the first quarter. Concerns over the credit markets and news of substantial write-downs by major banks caused investors to sell stocks broadly, especially early in the period.
Utilities, which outperformed strongly in 2007, performed roughly in line with the broader stock market through much of the quarter. However, when most stocks rebounded in late March in a relief rally after the Fed facilitated the proposed sale of Bear Stearns, utilities underperformed. This suggested that utility stocks—strong performers in 2007 in both absolute and relative terms—were overlooked as investors sought bargains in the most depressed sectors of the equity market.
The decline in utility stocks occurred despite a significant increase in natural gas prices, which are a key determinant of U.S. power prices—and therefore, in many cases, utilities’ profit margins. Next-month natural gas futures prices increased 35% in the period.
Our portfolios underperformed their benchmark in the quarter. Stocks that hindered performance included two demand-side management services companies. These stocks had sizable declines as investors sold anything resembling smaller technology companies. Some of our European holdings that had strong performance in 2007 underperformed in the first quarter, although we continue to view their prospects favorably. Factors that aided performance included our overweight in a natural gas utility company that disclosed favorable information on its natural gas reserves and long-term production growth.
Investment Outlook
We believe that utilities have the potential to outperform in what we expect to remain a choppy equity market, notwithstanding their performance in the first quarter. The recent surge in natural gas prices should result in higher market power prices. This in turn stands to result in upwardly revised earnings estimates and profit margins for utilities with low-cost generation such as nuclear companies (which are included prominently in our portfolios). The combination of lower equity prices—with utilities down 10% year to date—and positive earnings surprises, if they occur, should prove appealing in a broader market that we expect will face challenges.
Our long-term view on fundamentals remains favorable for utilities as well as non-utility infrastructure companies. Infrastructure companies share favorable characteristics with respect to supply and demand—foremost, high barriers to entry, inelastic demand for essential services and the need to upgrade aging distribution networks. While our primary emphasis is on traditional power and natural gas utilities, we continue to seek opportunities among companies involved in transportation infrastructure such as toll roads, ports and airports.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice and is not intended to predict or depict performance of any investment.
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