This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Michael Clark, portfolio manager of the Fidelity MoneyBuilder Dividend and Fidelity Enhanced Income funds, shares his outlook on utility stocks and the role that they currently play in his portfolios.
Utilities currently play an important role in providing my strategy with a safe and growing income stream, with positions in water and power stocks constituting around 16% of the fund. Traditionally, these have been the classic ‘defensive’ stocks, with little or no elasticity of demand for their product and a regulated return providing a very visible income stream for investors. For my approach, which emphasises safety of income at a reasonable price, this is the perfect type of investment.
I am often asked whether the gearing of the water stocks, and their relatively thin dividend coverage, should exclude them from my portfolio. It is certainly true that my process emphasises the importance of a strong balance sheet and a dividend supported by free cash flow, and in most other industries, the balance sheet and cashflow statements I see in the water stocks would not be acceptable. I have worked closely with the fixed income team to ensure that the debt burden on the company is sustainable and that servicing costs can be met by cashflow. The crucial point is that in water, the prices are set and the returns guaranteed by the regulator. This gives me confidence in the sustainability of the yield, and that investors’ capital should be protected through a period of market stress. I hold Severn Trent (SVT), United Utilities (UU.) and Pennon (PNN) in the sector.
This contrasts somewhat with the power stocks, where the outlook is rather more uncertain and where returns are not guaranteed. Recent policy announcements from the Labour party and ongoing popular discontent with energy costs create risks of enforced restructuring and price changes. These developments have resulted in me trimming some of the funds exposure to Centrica (CNA). It is possible that this selling may be extended if my conviction around the materiality of these risks increases. However, for the time being I am continue holding positions in SSE (SSE), Drax (DRX), National Grid (NG.) and Centrica, at a smaller size.