Why Utilities Is The Top Performing Sector

Analyst shares his views on the No. 1 stock market sector of 2016.

John Bartlett is portfolio manager and electric utility analyst for Reaves Asset Management. Reaves launched the first actively managed utilities ETF, the Reaves Utilities ETF (UTES | D-79), in September 2015.

Since then, utilities have exploded to the upside, powering UTES to a gain of 32.24% versus 29.3% for the Utilities Select Sector SPDR Fund (XLU | A-89). ETF.com recently caught up with Bartlett to get his take on the space, including why an actively managed utilities ETF is something investors should consider.

ETF.com: Utilities are by far the best-performing sector this year. Is that simply because interest rates on government bonds are moving down so much?

John Bartlett: Yes; generally speaking, utilities―especially in the short term―tend to react pretty swiftly to changes in interest rates. That's a reflection of the fact that utilities trade on their yield.
When you look at the average utility, its P/E [price-to-earnings] ratio is a function of its dividend yield. Typically, the higher-yielding utilities have a higher valuation.

As far as how utilities have been reacting to interest rates, the relationship isn't static. It does vary, and I would say that the spread to Treasurys tends to creep up a little bit as interest rates go lower.

If we go back to 2014, utilities were the best-performing sector in the stock market. That was a period when we were really worried about deflation, and interest rates were quite low. The spread―the utility dividend yield over the 10-year Treasury yield―ended that year at about 100 basis points.

Then we fast-forward to 2015, and utilities were amongst the worst sectors in the stock market. We ended the year at about a 200 basis point spread to Treasurys. Today we're at about a 160 basis points spread to Treasurys.

As far as I'm concerned, we're in neutral territory for utilities, with 100 basis points being too hot, and 200 basis points being too cold, with 150 basis points or so being about right.

ETF.com: Aside from interest rates, are there other fundamental factors you look at when it comes to utilities? What's their outlook for growth in earnings and things like that?

Bartlett: Utilities are one of the few places in industrial America where investors tend to underpay for growth.
We try to invest for total return, so our portfolio typically looks a little bit more "growthy," a little less "yieldy." We try to focus on companies that have the opportunity and the desire to grow their income a little faster than average over time.

The average utility on a market-cap-weighted basis grows its earnings around 4%. The utilities in our portfolio are little bit higher, in the 5% to 6%, maybe even 7% range. We have one big holding that's probably going to grow its earnings around 12% for the next few years.

The industry is in pretty good shape. If you look out over time, the relationship to interest rates is the most important one, but there's been a pretty steady improvement in the industry as well. That's been a component to the relative valuation improvement that we've experienced in the sector over the last five to 10 years.

Utilities have a nice opportunity to continue to invest money. The companies we own are by and large regulated, and so as the investment base grows, the earnings grow. As long as they get good recovery from the regulator, things look pretty good.

As long as you can do that in a predictable and stable way by―let's say, growing your earnings around 5% and having a dividend yield of 3.5 to 4%―you can steadily compound value in the high single digits.

If you can do that with a beta of about 0.5, that looks pretty compelling relative to the rest of the world.

ETF.com: Your fund, the Reaves Utilities ETF (UTES | D-79), is an actively managed ETF. Why do you think the utility sector can benefit from active management?

Bartlett: We've done this for a number of reasons. Yes, we believe we can outperform, and we've outperformed versus the index of utilities for a long time. We've been in business for 50 years, and we've managed money since '77.
But as far as utilities themselves go, my opinion is that there's a lot of risk that investors don't appreciate in the utility benchmark, specifically the Utilities Select Sector SPDR Fund (XLU | A-89).
When you look at the bigger index components, you see commodity exposure, and in some cases, the foreign exchange exposure. People just don't expect that. When they come to utilities, they have a belief that they're getting companies with a revenue stream that's acyclical―outside of the business cycle. If you look across the space, that isn't necessarily true with every company.

What we've done is we've been able to come to market with a product that's going to look, breathe and behave like the utility index that people expect them to have. Utilities are not an asset class; they're still common stocks, but they're a very special sector. And when people come to our sector, they have certain expectations about risk.
Outperforming is nice—adding alpha is more important. I personally look at keeping our risks lower than the benchmark and lower than the passive ETFs. I come to work every day to beat the benchmark. But to the extent that we can keep people's risk low, and add alpha as well, that's a pretty important objective.

Contact Sumit Roy at [email protected].