It would be fair to say that, traditionally, utility companies have not been viewed as the most exciting investments on the planet, with the sector consisting mostly of publicly owned or heavily regulated suppliers of basic amenities like water, gas and power. Nevertheless, as funds such as Ecofin Global Utilities and Infrastructure (EGL) have demonstrated, there are periods when these sectors do very well.
Generally, these companies sit in a quiet corner of a portfolio, minding their own business while providing stable, defensive earnings and mostly reliable dividend income. Considering these sorts of investments are generally seen but not heard, it may be surprising that three of the top 10 best performers in the S&P500 index, so far this year, are utilities.
The best of these, Vistra (held by EGL), is up 144%, beaten only by AI darling Super Micro Computer in the index rankings, followed by Constellation Energy ( also held by EGL, and up 87%) and NRG Energy (59%). All three are beneficiaries of the downstream effects of the AI boom and find themselves in the spotlight because they are capable of providing baseload energy to fuel the increasing power demands of energy-hungry data centres. There is no doubt that this opportunity provided by the AI revolution is considerable, as are the energy requirements with one estimate suggesting a possible increase of up to 400% over currently levels in the next few years, equivalent to around 2000 terawatt hours, placing considerable demand on existing infrastructure. One way of playing this is through Pantheon Infrastructure (PINT), which has a sizeable exposure to data centres and has highlighted the benefits that AI is bringing to this part of its portfolio.
In reality, energy demand to power the growing number of data centres is just one component of the massive amount of investment required to modernise the existing electricity grid to cope with the demands of a modern energy system. In the US alone, current estimates suggest around an 80% increase in electrical demand by 2045. Transport systems ( including the shift to electric vehicles) and buildings continue to electrify as economies decarbonise, while the decoupling of global supply chains drives increased manufacturing demand. To meet this demand, the grid will need to expand to handle three times the amount of clean energy flowing today, which means new transmission and distribution grid projects will need to be added at four times and 10 times their historical rates, respectively. Impax Environmental Markets (IEM) has recognised this and is backing an Italian company Prysmian, which manufactures high voltage power lines.
While the AI boom has provided the catalyst for the recent rally in a handful of targeted companies within the utilities sector, it is not clear that the scale of the wider energy transition is yet appreciated by the market, especially considering the changing nature of these companies. If you watched our recent interview with Jean-Hugues de Lamaze, manager of EGL, (click here to view) he observed that although long considered simple defensive plays for when things turn sour, thanks to modern revenue contracts, many of these companies are now capable of providing earnings and dividend growth comfortably ahead of broader market averages with managers in the sector targeting annualised returns in the high single digits. The shift in focus was on display throughout the first quarter of 2024 in the US, with the sector delivering the second highest (year-over-year) earnings growth rate of all eleven sectors at 23.9% (trailing just communication services which is dominated by Alphabet and Meta).
This newfound profitability adds to the appeal of the foundational defensive characteristics on offer, with many of these companies boasting inflation linked revenues and long-term power price contracts which act as a hedge against an increasingly uncertain economic environment. This came to the fore in 2022 with the sector comfortably outperforming broader market benchmarks as markets priced in a recession.
While economic prospects have improved since then, the outlook remains uncertain. This is especially true with the seemingly bulletproof US growth beginning to stutter (with both manufacturing and services falling into contraction territory) amid rising prices, with some commentators talking about an increased risk of stagflation.
We have long held the view that, with significant structural tailwinds driving long-term earnings growth and stable, inflation linked revenues funding reliable dividends, the sector offers a low-risk option for investors with significant growth upside. Despite this, the majority of investment companies in both the infrastructure securities and renewable energy infrastructure sectors continue to trade at substantial discounts to NAV. For example, EGL – which has exposure to both Vistra and Constellation Energy, and a diversified portfolio of other assets across the US, Europe, and the UK – may provide an attractive opportunity on a 13.4% discount. Alternatively, PINT is on a 20.8% discount and IEM is trading on a 12.1% discount.