Beyond Bulls & Bears

Power Plays

Does anybody remember last spring? If you do, you might recall the market riding a rally powered by optimism, since sidelined by doomsayers fond of dim predictions about the fate of the Euro, sovereign debt crises, and the possibility of a negative economic jolt due to a China slowdown. But at least one man, John Kohli, Franklin Utilities Fund manager, has retained his positive charge, citing the utilities sector as a respite of predictability in an often otherwise unpredictably bumpy marketplace:

John Kohli
John Kohli

“We’ve seen a lot of global actions that have caused their share of market disruption, though utilities overall remain relatively steady, dividend-paying securities with generally predictable income, earnings and cash flow. If anything, that’s been emphasized by market turmoil.” 

As the global population powers past the 7 billion mark, it’s not just increased consumption driving growth potential; it’s also clean environmental compliance standards. You read that right. As big producers of carbon dioxide and other particulates, utilities are increasingly investing in infrastructure to satisfy EPA and other federal agency requirements. Contrary to the usual perception that regulation is detrimental to business, Kohli explains how it can provide good growth potential when it comes to utilities:

“Environmental compliance is a big topic in the utility industry today and it can also provide good growth for this industry. EPA and other federal agencies have required utilities to be more compliant on a go-forward basis. So utilities have good growth potential out of environmental compliance through important capital investment in things like scrubber technologies and other back-end products on their power plants. These can be billion-dollar projects that are being put in place to clean up their emissions and help provide some growth because that translates into important long-term investment into improving the total franchise.”

While regulation leading to investment in new technologies and infrastructure is generally positive for the industry, it also merits careful analysis in markets where policy shifts can affect returns negatively. For example, some European countries have amended their regulation to extract and apply utilities profits to other sectors, which can result in diminished investment opportunity:    

“What’s happened in Europe has helped provide us greater clarity or greater conviction in our investment strategy. From a regulatory standpoint, we like to invest in states or countries where we have a great deal of confidence that the regulatory policies that are in place will remain in place. In Europe you’ve seen a lot of political intervention into the utility industries, so you’ve seen governments come and tax utilities for the purpose of bringing out the profits and distributing them to other areas of the economy.  In Italy, for example, they implemented what’s known in the utility industry as a “Robin Hood” tax: taxing the profits of the local utilities and distributing those profits elsewhere. We don’t like that and so we’ve largely avoided investing in Europe.[1]

Until next time, we leave you with this thought-sparking quote from Sir John Templeton:

An investor who has all the answers doesn’t even understand the questions.”

What Are the Risks?

In addition to other factors, securities issued by utility companies have been historically sensitive to interest rate changes. When interest rates fall, utility securities prices, and thus a utilities fund’s share price, tend to rise; when interest rates rise, their prices generally fall. These and other risks specific to the public utilities industry are described more fully in the fund’s prospectus.

[1]As of 9/30/11 Franklin Utilities Fund held 3 UK utilities companies.  Holdings are subject to change

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