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Managing an ETF Dedicated to the Utilities Sector

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Managing an ETF Dedicated to the Utilities Sector REPRINTED FROM SEPTEMBER 24, 2018 Managing an ETF Dedicated to the Utilities Sector JAY RHAME is Vice President and Portfolio Manager at Reaves Asset Management. Mr. Rhame joined Reaves Asset Management as a full-time employee in 2005. He is an energy and utility analyst. He is a member of the portfolio management team and is on the risk management committee. He also is Co-Portfolio Manager of the Reaves Utilities ETF. Prior to his current role, Mr. Rhame was employed as one the firm’s traders. Mr. Rhame received a B.A. from St. Mary’s College of Maryland and is a CFA charterholder. SECTOR — GENERAL INVESTING business but just a small part of the overall investment landscape. TWST: Do you work on a specific fund at Reaves There are not a lot of firms that are dedicated to the sector because Asset Management? it’s so small. We’ve taken the approach that in order to do well, Mr. Rhame: Yes, so specifically, I’m the Co-Portfolio you have to dive in, you really have to dedicate because the sector Manager on our actively managed ETF. It’s the Reaves Utilities is so complicated, and that’s what we’ve done, and our returns ETF, and the ticker symbol is UTES. But generally, we have a speak for that kind of focused philosophy. team-based approach on all our portfolios. TWST: What’s going on with the utility sector now TWST: Is there a unique investment philosophy at that would interest investors? the firm? Mr. Rhame: Right now, it’s interesting because utilities Mr. Rhame: Yes. If I could first just jump into a little always have a correlation — I guess an inverse correlation — background here. The firm was founded in 1961 and was founded with interest rates. Certainly, a lot of people come to the market as a utility boutique research firm, and it was actually a sellside for income. So when bond yields go up, it makes sense to sell company for a while. And then, as our commissions became your utilities and buy bonds. What’s happening below the negotiable in the mid-1970s, the firm here realized that we surface is that the growth outlooks for a lot of these utility couldn’t compete at the price points needed. You had to scale up companies are about as good as it’s been in a long time. to stay in that side of the business. So the firm had actually been Regulation generally has been stable and constructive. Except managing a portfolio in a profit-sharing trust. And a couple of for a few cases with wildfires in California and nuclear projects clients wanted to look at the returns and were excited about what in South Carolina, regulation’s been good. they saw, and our money management business started that way. There’s a lot of old infrastructure that has to be replaced, We started managing money in January 1978, and we’ve been and the companies essentially spend the money on infrastructure, doing that since then. and they earn whatever the allowed rate of return is, which is We are traditional investors. We’re long-only, equity- typically around a 10% return on equity, and are able to grow only, and we focus on the utility, communications and energy based on the amount of infrastructure they put to work. The real sectors. Since 1978, we’ve managed to beat the S&P 500 by a little benefit they’ve had is that power prices have come down a lot. over 100 basis points a year net of fees. By staying focused and Power prices 10 years ago, when natural gas was $10 a dekatherm, concentrating on what we think are hard-to-understand sectors, that was the main component of each customer’s bill. Today, that gives us a real opportunity. It’s really hard to be a large-cap natural gas is cheap, and the price of power is lower, and what value manager and compete when ETFs are giving away the S&P that’s done is relieve a lot of bill pressure and enabled a lot of 500 for free. It’s hard to find a real sustainable edge. companies to invest heavily in infrastructure. For us, utilities are only 3% of the S&P 500. Each state So just as background, utilities earn a return on the has different regulations, and utilities are also regulated by infrastructure they provide. Power is actually just a straight regional power authorities and at the federal level. It’s a complicated pass through to customers. So if power prices are high or low, MONEY MANAGER INTERVIEW MONEY MANAGER INTERVIEW ——————— MANAGING AN ETF DEDICATED TO THE UTILITIES SECTOR the utility doesn’t earn any money on that; they sell that power of just going in, tearing up old pipelines, replacing pipelines, to customers at cost. So when costs are low, that enables the making sure the water is safe, making sure it’s clean, and they infrastructure part of the bill to take on a little bit more there. have years and years of work. The way that’s played out in the So we see power prices staying low; natural gas is cheap, and stock market is investors have been much more willing to place a it’s abundant. Renewable energy has gotten a lot cheaper, and higher valuation on the company because they know that you it’s very competitive in a lot of the country. And that creates a have a 10-plus-year growth outlook, which is unique in the utility lot of headroom to replace a lot of industry. So that’s one. wires and distribution systems, gas We’ve seen some of the same pipelines, water pipelines, stuff like stories play out on the gas utility side that. So you’re starting to have Highlights as well. A company like Atmos these kinds of long-term backlogs Energy (NYSE:ATO), we’ve owned of projects, which is very different. Jay Rhame discusses Reaves Asset Management. for a while, and there, it’s a safety Utility industry growth Mr. Rhame co-manages the Reaves Utilities ETF, thing. They’ve actually been historically has been lumpy. They an actively managed fund. He believes that encouraged by regulators to go in, would go out and build a big power focusing on utilities, which he notes is a replace at-risk pipelines and keep the plant, they’d spend a lot of money for complicated sector, gives him opportunity and a system safe. Of course, there was an a couple of years, and bill increases sustainable edge. Mr. Rhame invests in explosion out in California in San would be close to double digits. companies that are going to be in business for a Bruno a few years ago, there was an Customers can only take so much, so long time, which helps him avoid big blowups. explosion in Harlem in 2011 or 2012, the utilities would have to spend a According to Mr. Rhame, growth has historically certainly a few of the hurricanes couple of years not really building flooded distribution systems, and all been lumpy in the sector but is a lot steadier anything, and you’d have this lumpy that showed the need to make the growth. today. With lower power prices, companies are systems safer. Today, growth is a lot able to invest in infrastructure. Regulators have created steadier. Most utilities are able to Companies discussed: American Water Works these programs where they’re grow earnings in the kind of 5% Company (NYSE:AWK); Atmos Energy encouraging the gas utilities to go in, range, but when you combine 5% Corporation (NYSE:ATO); DTE Energy Co. replace the systems and actually get earnings growth with a 3% or 4% (NYSE:DTE); NextEra Energy (NYSE:NEE) and automatic rate increases. Typically, dividend and also a dividend that’s Duke Energy Corp. (NYSE:DUK). utilities have to go through this fully growing at about the rate of earnings, litigated process of filing a case, the total return, it’s pretty attractive. having it spread out over a year, having So overall, it’s good. Interest rates many witnesses come in and answer will continue to be a factor, but I think questions. So to actually have a it’s more of a short-term impact. Longer term, growth looks good. program that enables to have automatic increases is a huge step TWST: Did you want to highlight a company that change for these companies. And so typically, the gas utilities are you find interesting right now? benefiting from that. Some of that exists for American Water Mr. Rhame: One of our long-term holdings is a Works as well, but certainly, we see long-time growth horizons for company called American Water Works (NYSE:AWK). They’re both those companies, Atmos and American Water Works. “Today, growth is a lot steadier. Most utilities are able to grow earnings in the kind of 5% range, but when you combine 5% earnings growth with a 3% or 4% dividend and also a dividend that’s growing at about the rate of earnings, the total return, it’s pretty attractive.” the largest publicly traded water utility right now. Their story is TWST: For both of them, is there a positive outlook fairly simple. They have water utilities in 10 or so states, maybe because a lot of communities are interested in infrastructure 13 states. What they do is, they buy systems, and they replace repair now, and there was some talk early on in the Trump water pipelines.
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