I see April performance for the S&P 500 as signaling the market shifting into neutral after gaining a tad less than +21% over the past twelve months. This typically coincides with a mindset change from a strong emphasis on concept to a greater concern with valuation. At the same time, I see the market as continuing its fascination with bot-think–that is, a focus on quick reaction to company news releases rather than on securities analysis that anticipates what they will contain. Cheaper, yes; more effective, I don’t know. If I’m right about the market mindset, however, then unusually little (vs. past experience) of economy better/interest rates higher is already baked in the cake.

For most of my investing career, Wall Street has looked at utilities as quasi-bonds, whose main attraction has been the dividend yield. This suggests they’re attractive if interest rates are falling and problematic if they’re rising. At the current weighting at 2.3% of the S&P 500 total market cap, they’re not top of mind for professional portfolio managers, whose two basic strategies are either to index-weight them or have none at all. The latter has been my preference, even during the 1980s, when rates were falling sharply from early-decade highs.

Also, as I’ve outlined in prior posts, because demand for utility output has been relatively stable for a long time, governments have had no issue with reducing allowable returns. In itself, this doesn’t reduce availability and it keeps voters happy. The predictable response of utilities to this has been to cut back on capex and maintenance, allowing plant and equipment to deteriorate.

For electric utilities, now dealing with creaky infrastructure + sharp increases in demand from AI and electric vehicles, this situation is beginning to change in their favor. The only way they’ll get the money for the new capital investment that today’s energy situation demands is if utility commissions raise the allowable return on assets that they can earn.

Two implications, if this is correct:

–allowable returns will move upward, although the timing and extent of government action on this is will require case-by-case study. The place I’d start to look is with my local electricity provider. A visit to the website and call to the investor relations or customer relations people may be revealing–either a goldmine of information or nothing at all

–companies will up their spending on new plant and equipment. The extent is probably large, but the timing is unclear. Ultimately, though, a wide range of equipment makers are likely the big beneficiaries. This is the way I’m participating, and through an ETF. No chance of a huge payoff by picking the winningest utility, but, I think, the best chance for me of a market-beating return, given my limited knowledge. This is basically the idea that the biggest winners from the 1848 Gold Rush were Levi Strauss and shovel makers.

When I began my career as an analyst, I covered a number of natural gas utilities for a while. I quickly learned that, ex maybe Arizona, electric utilities were long since mature entities, with little investment appeal other than their dividend yields.

Adding to their potential woes, as public utility commissions began to understand that the utilities’ service areas and customer counts were not increasing, there was no longer a need for them to tap the public markets for expansion funds. So the political calculus changed from granting generous returns that would attract new investors to whittling away at them to court voters through delivering lower utilitiy bills.

This last is the situation we’re in today.

But that’s only half the story.

Utility company managements, as I see it, didn’t just stand idly by and watch their profits erode. They followed three strategies, I think:

–they merged with one another. This allowed them to cut overall administrative expenses, and it permitted them to share support/emergency staffs. If, for example, three local utilities needed to have 100 repairpersons each on staff in case of, say, storm damage, their merger would allow the three to still have 100, but in the aggregate, rather than each. And 1/3 might be in New York, another 1/3 in Ohio and the remainder in Georgia–on the assumption that simultaneous emergencies in three different areas was highly unlikely.

–they cut costs. Maybe they lengthened depreciation schedules and replaced old equipment less often; or they reduced maintenance from gold-plated to silver-; or they introduced innovative machinery less often

–if possible, they separated business segments into different corporations, say, spinning off (high-profit) transmission lines from a (lower-profit) local utility.

boosting solar, too

For some electric utilities, the current situation has been made more difficult by state government requirements that they buy from customers excess power collected by their solar panels.

more tomorrow

A key tenet of the “Reagan Revolution” of the 1980s in the US, and the “Thatcher revolution” of the same vintage in the UK, is the idea that there are no such things as public goods. That is, everything is done better in the private sector than by government. Therefore, the #1 role of government is to shrink itself, to stop impeding the private sector’s ability to address national economic needs. That has turned out to be super-wrong, as evidenced by the parlous state of our transport and communication networks in the US. Better still, look at the UK.

I’m mentioning this here just to get the point out of the way. While important, this political stance is, I think, only a secondary factor in the present sad state of our public utilities in general, and of our electricity generation in particular.

public utilities

The argument in favor of them is that it’s better and much cheaper to have one or two monopoly providers of water, electric power, natural gas… rather than a whole flock of sub-optimal providers digging up the streets to reach customers and charging high prices in a vain attempt to reach breakeven. Instead, have a monopoly provider, monitored and regulated by a government commission which would set the prices the operator can charge.

Whether in hindsight this is the better system is a moot point. This is what we have.

the mechanics of the system

The typical (=only, as far as I know, but I’m not an expert here) method, is to set a maximum allowable annual return on the utility’s net plant and equipment.

“Net” here is the overall outlay on plant and equipment minus accumulated depreciation.

The utility meets with the commission periodically, bringing spreadsheets that show its actual and anticipated: number of customers, usage, input prices, overhead expenses and capital spending plans. Out of all of this, it sets unit selling prices for output that, if met, will deliver the commission-determined allowable return–no more, no less.

two cases:

— (1) the service area is growing steadily, so the utility is continually signing up new customers and adding plant and equipment. To finance this expansion, the utility is regularly turning to the capital markets to sell bonds, and occasionally new equity. In order to encourage investors to buy these issues, the utility commission has got to maintain a return on assets that’s high enough to assure them that the loans are safe and that the company can maintain rising dividend payments to shareholders

— (2) the service area is mature, demand is steady, no new financing is needed. In this case, there is no longer a strong incentive for the utility commission to set a high allowable return on assets. In fact, over the short term, at least, the situation is quite the opposite.

more on Monday

I was going to observe that last Friday’s panic about SMCI that send that stock down by 20% and NVDA down by 10% seems to have dissipated as quickly as it arrived. Then I noticed an article about the ARK funds in the Wall Street Journal.

Two excerpts:

–“By the end of last year, ARK funds had destroyed more wealth than any other asset manager over the previous decade, losing investors a collective $14.3 billion, according to Morningstar,” and

–“Investors have pulled a net $2.2 billion from the six actively managed exchange-traded funds at her ARK Investment Management this year, a withdrawal that dwarfs the outflows in all of 2023. Total assets in those funds have dropped 30% in less than four months to $11.1 billion—after peaking at $59 billion in early 2021, when ARK was the world’s largest active ETF manager.”

My thoughts:

–in my experience, redemptions like this almost never happen. ARKK is down by about -16% ytd, accounting for a big chunk of the drop in assets. That’s vs. NASDAQ at +5.5%. The more typical pattern in a situation like this is that holders are very resistant to recognize losses and will hold on instead in the hope that the fund will eventually reach their breakeven. At that point virtually nothing the organization can say or do will prevent them from selling

–as of the semi-annual report of 1/31/24, ARKK had assets of $7.5 billion and unrealized losses of around $9 billion. This latter is in addition to realized losses of $2.6 billion. As Ms. Wood pointed out last year, these losses have a considerable value. To get a ballpark number, if we were to say the total losses are $12 billion and that they could be used to offset what would otherwise be taxes paid at at 33% rate, then they have a value of $4 billion. This suggests that they’re by far the largest asset in the ETF

–a turnaround typically starts with a fund restructuring under a new manager, including a concerted effort to monetize the tax losses. I have no reason to think that’s going to happen here, though.