Introduction: Market Backdrop Calls For Investors To Think Defensively With interest rates hovering near historic lows – and central banks confirming their intentions to keep them there – the need to reassess risk in portfolios has never been clearer. At current yields, the probability is low that many fixed income investments will outperform inflation unless rates decline even further. Amid this backdrop, reducing the risk in the equity portion of investment portfolios may also be prudent with stock markets near record high levels. This likely means complementing existing equity strategies with more defensive ones that strive to produce attractive long-term returns but with lower volatility and better downside protection. Reaves’ Long Term Value Strategy 1 may serve as a valuable, defensive complement. When an adviser allocates to this strategy, they are increasing their weightings in companies and sectors that have defensive characteristics and a history of performing well when equity markets have below average returns. 2 In the following, we explain our essential service infrastructure approach, and why we believe it presents a better risk/return profile relative to other equity strategies. The Case For Essential Service Infrastructure “LOSS AVOIDANCE MUST BE THE CORNERSTONE OF YOUR INVESTMENT PHILOSOPHY.” - SETH KLARMAN “KNOW WHAT YOU OWN, AND KNOW WHY YOU OWN IT.” - PETER LYNCH
Transcript
Introduction: Market Backdrop Calls For Investors To Think Defensively
With interest rates hovering near historic lows – and central banks confirming their intentions to keep them there – the need to reassess risk in portfolios has never been clearer. At current yields, the probability is low that many fixed income investments will outperform inflation unless rates decline even further. Amid this backdrop, reducing the risk in the equity portion of investment portfolios may also be prudent with stock markets near record high levels. This likely means complementing existing equity strategies with more defensive ones that strive to produce attractive long-term returns but with lower volatility and better downside protection.
Reaves’ Long Term Value Strategy1 may serve as a valuable, defensive complement. When an adviser allocates to this strategy, they are increasing their weightings in companies and sectors that have defensive characteristics and a history of performing well when equity markets have below average returns.2 In the following, we explain our essential service infrastructure approach, and why we believe it presents a better risk/return profile relative to other equity strategies.
The Case For Essential Service Infrastructure“ LO S S A V O I D A N C E M U S T B E T H E CO R N E R S TO N E O F YO U R I N V ES T M E N T P H I LO S O P H Y.”- S E T H K L A R M A N
“ K N O W W H AT Y O U O W N , A N D K N O W W H Y Y O U O W N I T.” - P E T E R LY N C H
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Essential Services Defined
At Reaves, we love investing in essential service businesses because of our belief that the char-acteristics of these companies lead to better outcomes. Our highly specific, targeted approach to portfolio management has enabled us to generate attractive returns over full market cycles with less volatility than broad stock market indexes3. Ever since we began managing equity portfolios in 1978, focusing on the downside risk in each investment we make has been a cornerstone of our investment philosophy. The expertise we have developed from decades of researching and analyzing infrastructure-related stocks has led us to favor a specific set of company characteristics which include, but are not limited to, the following:
• Operate in businesses with high barriers to entry• Face limited competition, but higher regulatory scrutiny• Have historically low risk of bankruptcy• Generate consistent, sustainable cash flows• Produce net profits in both up and down economic cycles
This lower risk approach to equity investing has been demonstrated by the investment returns we have generated. The Reaves Long Term Value Strategy was profitable in 99.8% of all five-year rolling return periods4 since inception, from January 1978 to December 2019. The single unprofitable five-year period resulted in a cumulative loss, net of fees, of only 1.5% [see Appendix].5
Our annualized returns6 since inception have exceeded those of the S&P 500 Index7.
These outcomes are the direct result of embracing companies which we believe will stay in business for a very long time, steadily grow assets and cash flow and benefit from various new opportunities as they present themselves over time. For example, utilities are building new generation plants powered by advances in wind and solar technology. Operating expenses are declining as older fossil-fuel based generation plants are closed. Cable companies are becom-ing more profitable by transitioning away from their traditional multi-channel video services and toward the provisioning of high-speed broadband connections to meet insatiable data demands related to entertainment, education, and healthcare. Wireless tower companies are beneficiaries of each new upgrade in mobile network technologies and data centers continue to ride the wave of growth in cloud computing.
By investing in companies and sectors that provide such critical and vitally important services to consumers and businesses, the risk of owning stocks that suffer permanent impairments of capital is lower. We believe in this maxim: avoid the losers and the winners will take care of themselves. When the risk of an outsized loss is low, we can be more patient investors and let the power of steady compounding work in our favor. The number of companies in other industry sectors, such as technology and financials, that go out of business in any five-year time period is much higher and thus comes with more risk.
Our concept of essential service infrastructure is born out of our bottom-up research approach within the vast universe of global infrastructure investment options. Over our Firm’s history, we have focused on a few select, non-discretionary industries on which our modern economy depends: regulated assets, such as electric transmission and distribution, gas transmission and distribution, and water distribution and wastewater treatment; communication assets, including wireless service providers, communication towers, data centers, and cable/broadband systems; and transportation assets, including railroads, oil and gas pipelines, and distribution logistics.
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These businesses generally operate with limited competition and most are relatively insensi-tive to economic weakness. Additionally, regulators in certain sectors incentivize operators to deliver consistent, uninterrupted service and promote system modernization.
Since our founding, we have developed and applied our expertise in this select group of infra-structure sub-sectors and with it our investment process. This disciplined approach is critical to balancing the risks inherent in equity investing with our desire to not lose money.
Favorable Characteristics of Essential Service Infrastructure Companies
The absolute last items a household or business can cut from its budget are those which are inherently necessary to function. While that is a primary characteristic of companies that we favor, there are several other important ones which are highlighted below:
HIGH BARRIERS TO ENTRY
The capital intensity of most companies in this universe combined with the virtually insur-mountable hurdles to obtain zoning and regulatory approval to build competing networks are among the reasons these assets are so valuable and the earnings power so durable. At this time in the U.S., it is either impossible or, in our view, uneconomic, to attempt to lay new railroad tracks, erect long-distance high-voltage transmission lines, overbuild existing fiber optic or coaxial cable networks, or design and build a competing network of wireless communications towers. In recent years, opponents have also been successful in prohibiting construction of new pipelines for the transport of oil and natural gas.
LIMITED COMPETITION
Incumbent companies in certain sectors face limited competition, not only because of high barriers to entry, but also because of existing regulatory structures. Local electric utility compa-nies in most jurisdictions of the U.S. have been deemed to be natural monopolies and benefit from scale and network advantages that would be impossible for a new entrant to replicate. Competitors may be further disadvantaged during the ongoing transition to renewable gener-ating facilities as utilities build large-scale solar and wind farms and enjoy cost advantages in the bulk purchases of materials and the deployment of labor.
Historically, threats to broadband cable operators from competitors trying to build a similar network have not materialized due to unworkable economics and/or technical limitations. In most regions, incumbent cable operators compete against a single local telephone company which utilizes an inferior network that is slower and less reliable. The network architecture for wireless communications provides a distinct advantage to incumbent tower companies who have already secured the premium locations; competitors are slowed by zoning hurdles, network architecture challenges, and very high switching costs. Co-loca-tion data centers, sometimes referred to as carrier hotels, benefit from powerful network effects. They experience extremely high retention rates as the physical epicenter of cloud commerce.
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LOW RISK OF BANKRUPTCY
Highly regulated companies are required to maintain conservative balance sheets and capital structures. This increases their ability to service debt and puts them at lower risk of bankruptcy than many companies operating in other industries. It is also in the public good to insure unin-terrupted electric, water, transportation and communication networks. For these reasons, we see very few bankruptcies in the infrastructure names we are focused on.
SUSTAINABLE EARNINGS
Increased utilization and the inherent need to strengthen grids, harden networks and invest to ensure service reliability has and will promote sustainable earnings for essential service infrastructure assets. For example, regulated electric and water utilities submit rate cases to their state regulators in order to determine their allowed return on equity for necessary maintenance and reliability capital expenditures. Under this framework, companies are then able to pass these costs to their customers and offer investors a clear, regulatory supported runway for earnings while promoting reliable service for the public good.
The insatiable demand for mobility and wireless broadband services has led to regular auctions of wireless spectrum by the government to carriers who deploy it on towers to expand capacity and improve the quality of service. More compelling leases are created for tower companies by this ongoing cycle of spectrum provisioning and network upgrades.
The global transition to cloud computing should continue to benefit data centers, especially those whose premium locations are allowing businesses to interconnect in the same facilities. As more businesses co-locate within a data center, cloud service providers are incentivized to also locate there to help manage the data needs of these businesses. The resulting network effects are powerful, difficult to disrupt, and provide support for the earnings growth of the data center operators.
PRICING POWER
The relatively inelastic demand for critical services enables the owners of certain infrastructure assets to, over time, sustain and increase prices. Consumers place a high level of reliance on electric service, clean water, high-speed broadband and dependable wireless mobility. There-fore, they are willing to prioritize these services over others during weak economic periods. Wireless telecom tower owners benefit by having long-term contracts with wireless service providers. These contracts include above-inflation price escalators and additional fees every time carriers need to make network equipment adjustments in order to enhance service quality and remain competitive with other carriers.
PREDICTABLE CASH FLOWS
The long-lived assets associated with providing nondiscretionary services come with high development costs, but relatively low operation and maintenance expense. Combined with inelastic demand and pricing power/sustainability, the result is consistent, long term cash flows and, in turn, growing dividends, buybacks and sustainable earnings.
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List of Essential Service Infrastructure Companies
The table below categorizes the companies owned in portfolios managed with the Reaves LTV Strategy, as applied to Reaves’ LTV Wrap Composite as of June 30, 2020:8
In Summary
The common characteristics of essential service infrastructure companies and their defensive nature is why we believe that the Reaves Long Term Value Strategy should occupy a place in every investor’s portfolio. We focus on publicly listed infrastructure because it differentiates us from other institutional investors who typically use private partnership structures to gain exposure to infrastructure assets such as toll roads, tunnels, airports or satellite networks. Additionally, our strategy provides a variety of benefits relative to this approach, such as:
• greater liquidity;• portfolio transparency,• diversification of geographic and political risks related to single projects, and• ability to take advantage of short-term dislocations in the stock market.
Most importantly, this approach to investing in publicly listed essential service infrastructure equities has proven itself over a more than 40-year time period. Our clients have been able to assess the performance of our strategy in a variety of economic scenarios and stock market cycles. We believe that the strategy’s long-term track record is the result of buying companies with the characteristics detailed in this paper, coupled with avoiding businesses which ultimately succumb to competition or technological obsolescence.
REGULATED ASSETS
Alliant Energy American Water Works Atmos EnergyCMS Energy Edison International Eversource Energy Fortis NextEra Energy NiSource Sempra Energy
COMMUNICATIONS ASSETS
Alphabet Altice USA Charter CommunicationsComcast CoreSite Realty Crown Castle International Equinix SBA Communications T-Mobile US Telus
TRANSPORTATION ASSETS
Canadian National Railway Kansas City SouthernProLogis Union Pacific
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Reaves Asset Management is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration does not imply any skill or training. Reaves is a privately held, independently owned “S” corporation organized under the laws of the State of Delaware.The information provided in this blog does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. Investors should consider the investment objective, risks, charges and expenses of all investments carefully before investing. Any projections, outlooks or estimates contained herein are forward looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur.1 Reaves’ Long Term Value Strategy (Reaves LTV Strategy) seeks a high risk-adjusted total return. The strategy tends to be invested in relatively larger companies with strong balance sheets, good cash flow and a history of dividend growth. Core positions are accumulated in financially strong, high-quality companies and generally have the following characteristics: strong management, above industry-average growth rates, large/mid-mar-ket capitalization and low price-earnings multiples.Reaves performance data is the Reaves LTV ERISA Composite and, unless otherwise noted, all data is net of fees. The Reaves LTV ERISA Composite reflects the dollar-weighted return of all corporate ERISA pension accounts with assets of at least $1,000,000 under management for all periods presented (the minimum was $900,000 during the period 08/31/10-06/22/12). Returns are time-weighted and include the reinvestment of all divi-dends and other earnings, net of commissions. The LTV ERISA Composite does not reflect all of the Reaves’ assets under management. The LTV ERISA Composite ended on 12/20/19. Beginning December 2019, Reaves LTV Strategy is represented by the LTV SMA Wrap Composite. This composite contains those LTV discretionary portfolios with wrap (bundled) fees. Wrap accounts are charged a bundled fee which includes the wrap sponsor fee, as well as, Reaves’ investment advisory fee. Due to compliance requirements, the net-of-fees calculation is computed based on the highest annual fee assigned by any wrap sponsor who utilizes this portfolio in an investment wrap program (300 basis points from 1/1/03 through 12/31/16 and, effective 1/1/2017, 250 basis points). The LTV SMA Wrap Composite performance consists of money-weighted, time-weighted returns and it includes the reinvestment of all dividends and other earnings. The inception date of the composite is December 2002; however, the composite was created in January 2013. This composite has been managed in a similar manner to the LTV ERISA Composite which ended in December of 2019. The LTV SMA Wrap Composite does not represent all of Reaves’ assets under management.2 During all 5-year rolling return periods when the annualized return of the S&P 500 Index has been less than 10.0%, the Reaves LTV Strategy ERISA Composite (1/1/1978-12/20/2019) has outperformed the index 90% of the time. 3 Reaves LTV Strategy (Reaves’ LTV ERISA Composite for the period listed) outperformed broad-based stock market indices since inception in 1978. See tables below.
4 Rolling returns reflect the cumulative return on a continuously held investment over a number of consecutive periods, calculated monthly.5 The single losing five-year period was in the 5 years ended March 31, 2003. 6 An annualized total return is the geometric average amount of money earned by an investment each year over a given time period. The annualized return formula is calculated as a geometric average to show what an investor would earn over a period of time if the annual return was compounded.7 The S&P 500 Index (“S&P 500”) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The typical Reaves portfolio includes a significant percentage of assets that are also found in the S&P 500. However, Reaves’ portfolios are far less diversified, resulting in higher sector concentrations than found in the broad-based S&P 500.8 Securities with positions under 1% have not been included in this table.9 Standard deviation is a measure of the variability of returns-the higher the standard deviation, the greater the range of performance (i.e. volatility). The data shown reflects the deduction of investment management fees and/or transactions costs. Standard deviation is based on monthly data. The risk/return data shown are based on historical annualized rates of return and standard deviations of the Reaves ERISA Composite.10 Standard deviation is a measure of the variability of returns-the higher the standard deviation, the greater the range of performance (i.e. volatility). The data shown reflects the deduction of investment management fees and/or transactions costs. Standard deviation is based on monthly data. The risk/return data shown are based on historical annualized rates of return and standard deviations of the Reaves ERISA Composite.
The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all U.S.-stocks actively traded in the United States. As of December 31, 2019, the index contained only 3,473 components. The index is intended to measure the performance of most publicly traded companies headquartered in the United States, with readily available price data, The index includes a majority of the common stocks and REITs traded primarily through New York Stock Exchange, NASDAQ, or the American Stock Exchange. Limited partnerships and ADRs are not included. The typical Reaves portfolio includes a significant percentage of assets that are also found in the Wilshire 5000 Total Market Index. However, Reaves’ portfolios are far less diversified, resulting in higher sector concentrations than found in the broad-based Wilshire 5000 Total Market Index.
Annualized Returns6 1978-2019 Standard Deviation9 1978-2019Reaves LTV Strategy, net of fees 12.77% 12.8S&P 500 Index 11.84% 14.8Wilshire 5000 Index 11.87% 15.2
Source: eVestment Analytics
Annualized Returns6 1979-2019 Standard Deviation9 1979-2019Reaves LTV Strategy, net of fees 13.14% 12.7S&P 500 Index 11.97% 14.8Wilshire 5000 Index 11.93% 15.1Russell 1000 Index* 11.98% 14.9Russell 3000 Index* 11.93% 15.1Russell 2000 Index* 11.42% 19.2
* Index inception 1/1/79; Source: eVestment Analytics
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The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The typical Reaves portfolio includes a significant percentage of assets that are also found in the Russell 1000 Index. However, Reaves’ portfolios are far less diversified, resulting in higher sector concentrations than found in the broad-based Russell 1000 Index.The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The typical Reaves portfolio includes a significant percentage of assets that are also found in the Russell 2000 Index. However, Reaves’ portfolios are far less diversified, resulting in higher sector concentrations than found in the broad-based Russell 2000 Index.The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable US equity market. The typical Reaves portfolio includes a significant percentage of assets that are also found in the Russell 3000 Index. However, Reaves’ portfolios are far less diversified, resulting in higher sector concentrations than found in the broad-based Russell 3000 Index.Past performance is no guarantee of future results.All investments involve risk, including loss of principal.All data is presented in U.S. dollars.Important Tax Information: Reaves Asset Management and its employees are not in the business of providing tax or legal advice to taxpayers. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
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