Investment markets worldwide continued their negative momentum in the third quarter, making 2022 one of the worst years on record in equities and fixed income alike. Inflation continues to be the focal point for investors as the Federal Reserve Board has clearly stated that their only objective now is to tame inflation through higher interest rates and the draining of excess liquidity. Many are asking if the U.S. is in a recession. The markets are starting to assume a recession, but the economic data suggests we have not yet entered one. We must remember that markets typically hit their lows before the worst pain is felt, as investment markets are forward-looking and will discount before we feel it in the economy.

As measured by the MSCI All Country World Index, the global equity market declined 7.2% for the quarter. Adding in the loss from the first half results in a 25.7% decline for the world equity markets in the first nine months of 2022. Auour equity strategies outperformed their benchmarks, falling 5% in the quarter and 19% for the year through September.

Growth companies across developed markets continued their decline yet outperformed modestly value during the quarter. While growth companies fell 3.5%, value experienced a 5.6% decline in the third quarter as recession concerns rippled throughout all aspects of the economy. Though the dispersion in returns between value and growth companies year-to-date has narrowed a bit, the underperformance of growth companies is expected to continue as investors look for more near-term certainty that value companies provide versus the long-term opportunity that many growth companies look to promise.

Smaller companies suffered a bit less in the third quarter, falling 2.1%. We would love to say this is a positive sign for future returns, but at this time, it seems a bit like a consolidation of past losses rather than a change in trend. Other riskier equity categories continued to produce declines. Emerging markets declined 13% in the quarter, culminating in a loss of almost a third of their value over the past nine months.

Fixed-income markets also continued declining, falling 6.9% as market participants digested higher-for-longer inflation expectations and the increasingly hawkish tone from the U.S. central bank. Investors have grown accustomed to having fixed income stabilize a portfolio when equities weaken, but this year has been different. Fixed income dropped 20% in the year’s first nine months, adding insult to injury felt from equity allocations.

There were no places within the fixed-income markets to hide from price compression, as the impact was felt across the entire yield curve and every credit category. Staying the course with our defensive positioning in lower-duration instruments paid off and helped to dampen the decline. Auour fixed income strategy performed relatively well in the quarter, falling 3.3% compared to its benchmark falling 6.9%. Through September, Auour has experienced an 11% loss in fixed-income relative to the market’s 20% decline.

The concerns we have shared over the past two years continue to reveal themselves in the investment markets. Though we have focused most of our conversations on our concerns, it is imperative to remember that markets can quickly discount the negatives. Historically, as fear of continued declines grabs headlines, it is at these times that long-term investment opportunities present themselves. We need to remember that economic storms pass and bring about clearer skies. Our high cash levels allow us to weather the storm and look for opportunities as the skies brighten.

In the quest for current income, it has made sense to find those firms and industries that can provide a good and steady stream of dividends.  For longer than the past decade, utilities have fit that need.  However, they are approaching a point where the sustainability of those dividends is at risk.  Using the XLU components (i.e. Duke (DUK), Southern Company (SO), Dominion (D), etc) as a foundation for this report, it becomes clear that what has worked for the past 10 years, may not work over the course of the next 10 years.

This note is by no means exhaustive.  The intent is to start an ongoing dialogue around the lack of sustainability in the dividend policies of many within the sector.

Figure 1: Cumulative Cash Sources and Uses (Bloomberg, CapitalIQ)

Figure 1 looks at the cumulative cash production, disbursement, and capital structure of the 31 companies that make up the XLU over the course of the past 12 years.  Over the past 12 years, the utilities that make up the XLU have generated operating cash flow of approximately $593B and yet have had capital expenditures that nearly approach that same level ($580B).  This has resulted in those 31 utilities generating a total of $13B in free cash flow, cumulatively, over that time period.  That appears to be the extent of the good news.

The shock comes from the fact that they have paid out cumulative dividends of $147B over those same 12 years, more than 10x times the amount of excess cash they have generated.  To fund this payout, they have taken on an additional $113B in debt.

With cash being king, the above data makes it hard to see how the industry can continue the current dividend policies.  And the supporting data only reinforces the tenuous situation.  In the table below, we look at the 10 year average of a few statistics for the top 10 members of the XLU.  Over the course of the last decade, the top 10 had an average return on assets of 3.2%.  This is 73% of the dividend yield and 67% the cost of their debt.  With this data, it is difficult to understand how the returns to either the equity holders or the debt holders can be sustained.  To add to the issues, at least for the equity holders, the payout ratio is uncomfortably high at 73%, almost 20% above its 10 year average.

Table 1: Top 10 Utility Statisitics (Bloomberg, CapitalIQ)

The case is not being made that the dividends are at risk of being cut in the short term (though they probably should in my modest opinion).  The analysis being presented simply states that the current level of dividends can not go on indefinitely.  And, as important, the current capital structures leave little room for error if the access to capital changes.  With the most recent outflows from bond funds, one should be concerned that access to capital could change soon.

Breakdown of the Top 10

The intent of the report is to highlight the increasing risks within the industry.  However, it is worth digging deeper into the individual companies within the industry as the outlook becomes even worse.  Looking just at the top 10 utilities that make up almost 60% of the value of the XLU, we can see some interesting detail.

At first glance, the dividend growth experienced over the past 10 years does not look out of line with the growth in net operating cash flow (also known as Cash Flow from Operations).  As shown, all but PPL and EXC have produced a growth in OCF above the growth in their dividends.

Figure 2: Growth in OCF and Dividends (Bloomberg, CapitalIQ)

However, that may create a false sense of security once the data is distilled down a little more.  Cash from Operations is a sturdy measurement of cash generated by operating activities but it does not tell the entire story.  It runs the risk of being transient as changes on the balance sheet can distort the long term cash generation potential of the operating activities.  Once we look at the EBITDA growth for the main players, a different view comes to the surface.

Growth in OCF has outpaced the growth in EBITDA for all of the top 10 utilities in the XLU.  And in most cases, it has been by a material amount.  It is important at this point to discuss briefly the delta between OCF and EBITDA.  While EBITDA describes the cash profits collected by a firm, the OCF includes the changes that incur on the balance sheet in order to operate the company, i.e. the impact of changes to working capital.  Over time, it should be expected that we see a convergence between the two rates for low growth companies.

What becomes obvious from figure 3 is that the top 10 utilities have been able to take cash off of their balance sheets at a rate faster than the cash they have generated through profits.  This is not a bad outcome but it should not be considered sustainable over the long term.  Therefore, to gain comfort in the future dividend stream, one needs to look at the growth in the excess capital generated by the firm.  EBITDA is a good proxy for that (at least to start).

Figure 3: Growth in OCF and EBITDA (Bloomberg, CapitalIQ)

As we look at the growth in EBITDA (figure 4) for the top 10 utilities over the course of the last decade, more issues start to appear.  In 6 out of the 10, dividend payments have grown faster than their profit generating ability.

Figure 4: Growth in EBITDA and Dividends (Bloomberg, CapitalIQ)

Looking at EBITDA is instructive but only half the story.  In order to generate those profits (i.e. EBITDA), capital expenditures are required, debt must be serviced, and taxes must be paid.  And as shown below, those three expenditures have needed all, and more, of the profits generated, leaving nothing for the equity holders.  In only one year, has the group been able to fulfill its dividends in a natural, self-sustaining way.

Table 2: Historical Industry Cumulative Financials (Bloomberg, CapitalIQ)

Conclusion

All of this confirms the initial conclusion that the dividends of the utility sector are not sustainable.  And that is with many factors being in their favor.  Those include, but are not limited to, an open and favorable capital market, low rates, and a mix to low cost energy sources.

With the risks of competition (from IPP’s), the need for added infrastructure upgrades, ongoing need to invest in renewables, and the likelihood that the cost environment can only go in a less favorable direction (through natural gas prices and interest rates to name just two), the idea that the next 10 years will be better for the industry’s operations look way too optimistic.

The costs to do it well.

Large firms spend large sums of money to hire analysts specializing on understanding the drivers of an industry, the key players within it, the subtlety of a management team’s focus and drive.  As I was one of those guys, I traveled quite a bit to meet face to face with management teams.  Riding in the delivery trucks to meet customers, speaking with suppliers, etc.  All with the idea to develop a deeper understanding into the means a company drove value creation… or destruction.  I was trained by ex-CIA interrogators on methods to question management teams to detect deception.  We retained forensic accountants to go through companies’ financial statements.  These are the actions of the large mutual fund complexes, institutional asset managers and the established specialized hedge funds.  It must be viewed with a skeptical eye when someone attempts to invest in single securities without this level of detail.  Their competition is doing it.  If they are not, I suspect that they may be at a disadvantage.

Reinforced with empirical evidence

This is not to say it’s impossible to outperform these large complexes.  I will be the first to suggest that the large institutions have their own problems that harm their chances to outperform on a consistent basis.  But one must be cognizant that a a manager in the suburbs with limited resources has considerable headwinds.

To make matters worse, considerable evidence suggests that between 63% – 95% of professional managers underperform their mandates.  This has been shown to be true across investment styles, market caps, and economic conditions.  So, the net effect is that you need to believe that your manager is in the top 5%-20% of all managers around the globe to justify his desire to stick you in individual securities.  Those aren’t great odds…

The elephant in the room

To make matters even worse, stock picking may not even be that important compared to other factors.  In repeated studies, it has been shown that over 90% of the variation in individuals’ historical returns can be attributed to two factors; market participation and asset allocation.  That would indicate that individual stock selection has a very minor impact on your long term returns. Combine that with the fact that most managers underperform, it’s hard to understand why you should pay them for their skill at all.

All is not lost

It may sound like I am being harsh towards active managers.  I am.  Most deserve it.  Not all of them, but most.

The above studies’ results have most definitely influenced the architecture and processes of Auour. From a rational review of the current research, we have decided to approach investing by attempting to control the factors that drive performance; market participation and asset allocation.  And to do so with an eye on costs.

The above is not to say that all active managers are poor.  We are true believers that great investors exist.  Our experiences suggest that they focus on small companies or more esoteric investments where information inefficiencies tend to be larger.  Auour looks to identify those that have demonstrated skill over the long term and over various economic conditions and integrate them into a cohesive investment plan to drive stability in philosophy, durability in process, and performance in our clients’ assets.