Jamie Clark

Time to plug into a utility stock

Jamie Clark

National grid


The idea of an equity income manager buying a utility wouldn’t usually warrant comment. Conceptually, utilities are crushingly dull businesses. Because they provide essential services, operate within a defined regulatory context and enjoy limited competition, they offer stable earnings and dividends. This part explains the ‘bond-proxy’ tag that dogs them, as well as their enduring popularity with income investors. But this is an enthusiasm we haven’t shared since 2012, when International Power, the last utility we owned, was bought by GDF Suez (which renamed to Engie).

 

There are three reasons behind the long-running absence of utilities from our portfolios – declining UK power demand, political interference and latterly, higher interest rates:

 

  • Declining power demand flows from the changing mix of the British economy and gains in household efficiencies [1]. We read this as a threat to earnings, debt sustainability and dividends.
  • Political interference was an extension of the antibusiness fervour that followed the Global Financial Crisis (GFC); Labour’s 2017 pledge “to bring key utilities back into public ownership” [2], illustrating the threat such attitudes posed to capital.
  • We expected higher rates as a result of a gradual normalisation of financial conditions following the GFC. Higher rates bear consequences for leveraged, capital-intensive businesses like utilities.

 

While the FTSE Utilities Index largely tracked the wider market in the first few years following our exit from the sector, vindication of our underweight position came in the form of a marked period of underperformance since July 2016. Since then, the FTSE Utilities Index has returned -16.3%, underperforming the UK market by 30%*.

 

But circumstances change and the sector’s underperformance has led us to review our stance. The upshot is that we have initiated a new position in National Grid, owner of electricity and gas transmission networks in the UK and US. Why the change of heart? We aren’t contrarians, but we do like mispriced assets. Our Macro-Thematic method involves finding companies where valuations don’t reflect long-run potential.

 

In this case, the utilities sector’s fall resulted in National Grid derating by one third on a prospective p/e basis. Take into account capital structure, or debt, and the company’s EV/EBITDA (enterprise value/earnings before interest, tax, depreciation and amortisation) multiple contracted by 2.5 points to 9.5x. Staggeringly, this left it trading at only an 11% premium to its UK assets, relative to a 10 year average of 34%.

 

National Grid share price premium to UK Regulatory Asset Value 

 

Cheap is fine, but what’s the Macro-Thematic relevance and why should we expect share price appreciation and security of dividend income? In short, the reason is the advent of electric vehicles (EVs) and the bearing this has on demand for power. On this count, National Grid slots neatly into our existing EV-inspired Battery Revolution basket, complementing our position in battery materials prospect Johnson Matthey.

 

Across the world, governments are mandating the end of the internal combustion engine and encouraging the take-up of greener, zero-emissions vehicles. China leads the way for EV sales and Norway is the leader in terms of market penetration [3].

 

More modestly, there are presently 157,981 low emission vehicles in the UK, equating to just 0.4% of all licensed vehicles [4]. But UK politicians are set on changing this. The government’s recent ‘Road to Zero’ document outlines its ambition to ensure that 50% of new car sales are low emission by 2030; and for all new cars to be zero emission by 2040 [5].

 

There are significant implications for electricity usage. National Grid’s ‘Future Energy Scenario’ paper estimates that by 2050 there will be 31.7 million EVs in the UK. Correspondingly, it forecasts that electricity demand for transportation purposes will grow from less than 1 terawatt in 2017 to between 65 and 89 terawatts by 2050, equating to nearly a quarter of total demand, from a base of virtually nothing [6]. This offers a counterweight to demand trends in the industrial and domestic sectors.

UK Electricity Demand - Transport

Simply put, National Grid stands to gain from rising UK electricity demand. With 35% of group assets and 31% of earnings attributable to UK electricity transmission, we get some idea of how significant this may be. These figures exclude the as-yet unquantified opportunity of installing UK EV charging infrastructure and the electrification of vehicles in the US (National Grid owns grid assets in New England and upstate New York).

 

But what about political risk? Whilst Labour’s enthusiasm for nationalisation is undimmed, it’s unclear that they could win an election. Even if they did, we’re confident that reality would frustrate their agenda. At an estimated £300bn, their nationalisation programme seems prohibitively large [7]. Which says nothing of its legality, or impact on investment, gilt yields and the UK’s debt burden.

 

Further, compared to those utilities focused on supplying consumers, National Grid’s infrastructure business seems immune to the public outcry and political reaction that typically accompanies price hikes. 

 

As for higher rates, it’s true that utilities are leveraged and bear interest rate risk. But, the evidence of October’s violent market correction suggests the effect on National Grid’s share price isn’t linear. In fact, as sovereign yields spiked and equities capitulated, National Grid returned 4.8% on the month as the FTSE All-Share Index lost 5.2% (source: FTSE). To us, this implies investors could seek refuge in utilities, as higher yields wrest market leadership from expensive ‘growth’ stocks and ‘value’ takes up the baton.

 

It’s been a while, but now feels like a good time to embrace the comforting dullness of a utility like National Grid. 

*source: FE, as at 30 November 2018

[1] Department for Business ‘Energy Consumption in the UK’, July 2018.

[2] Labour Party ‘For the Many not the Few’, May 2017.

[3] McKinsey ‘China’s electric-vehicle market plugs in’, July 2017.

[4] www.gov.uk/government/statistical-data-sets/all-vehicles-veh01#ultra-low-emissions-vehicles.

[5] Department for Transport ‘The Road to Zero’, July 2018.

[6] National Grid ‘Future Energy Scenarios’, July 2018.

[7] CPS ‘The Cost of Nationalisation’, Jan 2018.

For a comprehensive list of common financial words and terms, see our glossary here.

 

Key Risks 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Macro Thematic team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. The performance of the Liontrust GF Macro Equity Income Fund may differ from the performance of the Liontrust Macro Equity Income Fund and is likely to be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Tuesday, December 4, 2018, 11:54 AM