Why Neil Woodford’s outrage is good news for utilities

By Associate Editor David Stevenson Jul 30, 2010

David Stevenson

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Wind turbines

Great news for this sector

Having a pop at financial markets has been all the rage in recent months.

Although politicians like it when share prices rise, when the message from the markets isn't what governments want to hear, they moan about "irresponsible speculators creating uncertainty".

But cheap, populist potshots at the market ignore one important fact.  For investors like us, the stock market is about our money. Like the cash we've invested in our pension fund. Sadly, few people want to fight our corner on this score.

But here's the good news - now there's someone on the warpath. And he's having a go at the authorities on the behalf of shareholders.

High yield shares are one of the best bets around right now

What happens in the stock market really matters for many of us. You may own individual shares or the likes of a FTSE 100 tracker fund. Even if you don’t, then your personal pension is almost certainly partly invested in UK stocks.

And if you’re looking for income, and you can accept the potential risk to your capital, then high-yield shares look one of the best bets around right now. Most banks are paying almost zero interest on savings accounts, and ten year gilts only yield about 3.5%.

Yet even in the stock market, finding a decent income stream isn’t as easy as it was. BP’s dividend used to contribute £1 of every £7 paid to UK investors. But the oil giant’s once bumper payout has been blown away by the cost of repairing the Gulf oil spill damage. I wouldn’t bank on it being restored to its former glory anytime soon.

That throws the share income spotlight onto defensive areas such as telecoms and ‘big pharma’ - we’re always recommending these, including in this week’s MoneyWeek magazine cover story. And near the top of the high dividend payout list come utility stocks, such as electricity and water suppliers. These pay some of the largest yields around.

The problem with regulators

Yet there’s a snag for investors. Utilities can have their style cramped by close scrutiny from regulators – Ofgem for energy utilities and Ofwat for water.

Of course, these regulators are under pressure to stop prices paid by consumers rising too fast. But utility companies also need to make enough money to attract investors by paying decent dividends. They also have to fund their future capital expenditure.

In other words, this isn’t about lining shareholders’ pockets. Unless utilities can charge their customers enough to pay their own bills, Britain’s energy and water infrastructure will take the hit. It’s a huge issue. Just to meet our climate change obligations - and produce enough power, too - this country is expected to have to spend £200bn on new energy production facilities in the next 10 years.

Cue Neil Woodford of Invesco Perpetual. He runs income funds worth around £17bn. Over a quarter of this is invested in the utilities sector.

And Woodford reckons investors in Britain’s utilities are getting a raw deal. What’s more, he’s saying so in no uncertain terms.

Last year he had a running battle with Ofwat, the water regulator, about its five-year pricing review. (We covered this closely while it was going on, and wrote about it last month in the magazine: Why you should bag a water stock). Last week he called Ofwat “dysfunctional”.

“We have to shoulder an increasingly anti-equity culture in Ofgem and Ofwat, whose public stance along with that of the government seems predicated on the achievement of the impossible – ‘more investment with lower prices’. We’re left to conclude there’s an unbridgeable gap between the regulators’ perception of what’s a fair return on equity and what we require on incremental investment”, he says.

In other words, utility firms aren’t being allowed to make enough money to do what they have to do. And it’s unfair to shareholders.

Now Woodford isn’t renowned for being stroppy. So “when he does stick his head above the parapet, it’s worth taking notice”, says David Prosser in The Independent. I won’t repeat all Woodford’s views here. In this week’s magazine, my colleague Simon Wilson has run through the Invesco Perpetual fund manager’s beef in greater detail: The future of energy.

But in short, Woodford says that unless regulators cut utility firms more slack on pricing and returns on investment, his funds won’t cough up any more cash to invest in these firms.

So what does this mean for investors in utility stocks?

Well, in the long run, it can only be good for the sector's price performance. Because either utilities get the leeway from the regulator to make more profits, and so investors will be willing to give them the financing they need to build more infrastructure.

Or if there's no investment, then Britain's energy prices will eventually have to rise for want of investment in decent infrastructure, which will push up profits in any case.

Now clearly, there's some sabre-rattling by Woodford going on here. The regulators have since defended their position and have also fired back, saying they've tried without success to talk to Woodford about these issues. No doubt they'll all get round the table at some stage. It's unlikely that Britain will end up with blackouts over this dispute.

But the City often gets flak for not getting involved enough in key ‘governance’ issues. You could argue that’s fair criticism. So it’s good to see someone getting stuck in – and fighting battles for investors against the authorities at the same time.

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Furthermore, shareholder ‘activism’ generally raises stock prices over time. The bottom line is that Woodford and his ilk hold all the purse strings. The government is so cash-strapped that it’s being forced to slash spending ever-harder. It couldn’t stump up extra wonga to build more power stations even if it wanted to. So the regulators will have to play ball with the utilities eventually.

But this isn’t just about one major investor speaking his mind. It’s the market in action. It’s important to understand that this isn’t about a nasty City fund manager trying to drive up the price of energy for the punter on the street. One way or the other, prices are going to rise anyway.

If Britain wants to keep the lights on, it will have to pay the bill for new infrastructure. Electricity providers are competing for funds with other businesses. So power prices must rise to make new investment in the industry more attractive. If this doesn’t happen, there will be power shortages, and the price of energy will have to rise anyway. Either scenario will be good for energy suppliers. But I think we can all agree on which option would be the best for the rest of us. It all reinforces our view that high-yield utility shares are one of the best places to be in the stock market right now. Water stocks have run up recently, meaning electricity suppliers look a better current bet.

If you’ve missed our earlier tips, to recap - here are two of them. Electricity supplier Scottish & Southern Energy (LSE: SSE) is on a 10.5 p/e and a 6.6% prospective yield, while transmission network owner National Grid (LSE: NG/) stands on a multiple of 11 and prospective yield of 7%. Woodford, by the way, owns 3.61% of it.

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Comments (9)

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  • 1. Martin Dormer

    (30 July 2010, 11:30AM)  Complain about this comment

    Your article gives a good airing to what might be termed the investors' viewpoint, and no doubt has validity, BUT the fact remains that on the other side of the fence, the UK consumer is seen as a cash cow by far too many companies, utility ones included. If EU energy prices were similar to ours, I might be more persuaded by what you say, but as long as UK prices remain quite a way above those of our neighbours I am more inclined to agree with the regulators.

  • 2. David

    (30 July 2010, 12:23PM)  Complain about this comment

    Neil Woodford should wind his neck in!
    Water utilities are closely regulated for a reason, because we have no option but to use our local water company. There is no competition and therefore they can charge whatever they can get away with and seemingly they do. We have had nothing but rain for a month in Manchester and yet we still have a hose pipe ban!! I wonder how big this years divident will be?? Where utilities, transport, energy and other essential services are concerned it is not the shareholder that should take priority, it is the customer.
    Centrica just made huge profits because they profiteered on a low wholesale gas price and charged their customers based on rising wholesale prices a few years ago without dropping their retail prices. This is just one example. We need something like a stakeholder model in some businesses instead of a shareholder model.

  • 3. andrewm

    (30 July 2010, 12:51PM)  Complain about this comment

    All this talk and importance placed on investing in 'safe' securities, surely is just another angle of many that exists. Most of which are of equal importance. Look at BP, look at other scenarios which might happen and send some of these 'safe' companies into a spin. At the end of the day a diverse portfolio consiting of securities in various industries is the best and needs to be promoted. Most times when one industry is down another one is rising. Maybe an industry tracker here and there.

  • 4. Supermarine Blues

    (30 July 2010, 01:55PM)  Complain about this comment

    Not normally one to defend the whiney leftie point, but whilst the utilities continue to treat their customers (developers in particular) with such utter contempt, they deserve negative growth!

    Address that and then Mr. Woodford's perfectly valid point.

  • 5. Ron

    (30 July 2010, 06:32PM)  Complain about this comment

    Ofgem do nothing for the consumer preferring to do the bidding of their paymasters. They will hopefully be abolished under the conservatives and replaced with people who will stand up for the British public.

  • 6. ken

    (31 July 2010, 11:09AM)  Complain about this comment

    It should be no surprise to anyone about the German economy given the anti-British negative reporting you produce day after day. In Germany they are to a man proud and promotional about their country and do not down talk at every opportunity.
    They have over many year promoted the myth of German efficiency and organisation and now the World believes it. You and your like do the opposite for our country. You should be ashamed of your continued self bashing rhetoric.

  • 7. Tom O'Neill

    (31 July 2010, 03:30PM)  Complain about this comment

    There'll always be an inherent tension between consumer and shareholder interests where a monopoly provider of essential services has been privatized. Customers will not willingly pay more for water in order to provide future capex, particularly not where they see the wasteful corporate neglect of leaks, and the prodigally free provision of those who plead poverty or simply do not pay their bills.
    Similarly, though energy is more competitively supplied, customers won't willingly pay more for gas to inefficient energy companies who buy wholesale at precisely the wrong moment and who lack the will to build stock provision.
    These are not competitive industries, they are nationalized utilities masquerading as private corporations.

  • 8. 4caster

    (02 August 2010, 12:26AM)  Complain about this comment

    The German "economic miracle" since 1950 has two main roots, upon which the victorious allies insisted: a system of proportional representation in government, and capital/labour partnership through company Works Councils. It is amazing how foreign rulers can often see what needs to be done to turn another nation's economy round.
    The UK, in contrast had suffered see-saw politics, with, for example, steel, nationalised and privatised again thrice between 1945 and 1985. And industrial strife has been rife, with capital and labour in opposing camps. Corporate governance is now my passionate issue. I and my co-shareholders, especially those whose shares are held through nominees such as ISA managers, have no say is the appointment of boards of directors, who can misallocate shareholders' funds into their own pockets and, through inflated staff bonuses, into activities against shareholders' interests.

  • 9. paul - manchester

    (02 August 2010, 10:49AM)  Complain about this comment

    as a consumer and an investor i can see both sides of the argument; my concern would be that the utilities managements would see increased profits as an excuse to award themselves massive bonuses, salaries and pensions which they have not actually earned through performance improvements.

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