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UTES: New Actively Managed Utilities ETF Targets Infrastructure

Summary UTES, a new ETF offered by Reaves Asset Management, is the first actively managed utilities ETF. Reaves intends to use its 37 years of experience with the utilities sector to build a portfolio that will feature growth. I was able to interview Joseph (“Jay”) Rhames, the fund manager, to get insights into the philosophy behind this fund. Utilities are one of the more popular sources of income for investors, with yields typically in the 3.00% – 5.00% range. Utilities are attractive because they are a defensive investment – these are the sort of companies that are constantly in demand, in terms of what they provide – namely, power . Everyone uses it, everyone needs it; everyone pays for it. In terms of growth , however, this may not be the most attractive segment of the market. As noted by one colleague, prices for utility stocks rose from the period of 2008 – 2014 primarily due to the fact that other sources of income (CD’s and money markets) were not offering much. 1 However, along with everything else in recent months, utilities have seen a drop in value. The extent to which this is associated with the general market declension remains to be seen, but utilities are not usually known for rapid growth, anyway. As an industry, utilities are usually regulated by local and state authorities, and regulators do constitute an effective cap on a utility’s potential growth. The Utilities ETF As we will see later in this article, ETFs do offer an interesting means of achieving effective yield from utilities. Until recently, all utilities ETFs have been passive, indexed funds; in September, however, Reaves Asset Management – a company that has been managing institutional portfolios since 1978 – decided to put its experience in the area of utilities behind an actively managed fund: the Reaves Utilities ETF (NASDAQ: UTES ). 2 Historically, Reaves has been intimately involved with the utilities sector, and has extensive experience working with utility management companies. UTES represents their effort to translate that experience into a marketable ETF that can improve growth prospects over those of passive funds. In preparing this article I had the opportunity to speak with fund manager Joseph “Jay” Rhame, III , about plans for the fund. 3 I came away impressed with the depth of understanding Reaves has of utilities and their awareness of the factors currently influencing the business. Selection UTES currently has 21 holdings, or about one-fourth the holdings of larger ETFs and fewer than half as many as the average for the eight other utilities-focused ETFs. No index is used in the selection of the holdings; Mr. Rhame is focusing on companies that are profitable , that may be underweight , and – in particular – companies that are oriented towards utilities infrastructure , rather than power generation. For purposes of the fund, a company constitutes a ” Utility Sector Company ” when either 50% of the company’s assets or customers are committed to, or at least 50% of the company’s “revenue, gross income or profits” are realized from “products, services or equipment for the generation or distribution of electricity, gas or water.” 4 Companies that are focused more towards power generation are subject to pressure from regulators who control prices; as a result, their share prices tend to be volatile , fluctuating according to changes in the regulatory environment. Infrastructure, on the other hand, is a more stable operation with regular demand and less influence from regulators ; this makes their business more reliable , improving prospects for share prices. Furthermore, the fund seeks (primarily U.S.) 5 holdings that display at least one of the following characteristics: They have conservative capital structures. They present solid balance sheets. They have a history of, and/or the potential for, growing earnings or raising dividends. There are positive catalysts that could potentially unlock value. Their levels of volatility, correlation or similar characteristics are lower than market levels. 6 Eligibility is independent of the company’s market capitalization; further, companies may be evaluated on earnings/cash flow potential, dividend prospects, strength of franchises and estimates of net asset value. 7 Weighting There is no formal weighting system for the holdings; rather, holdings are evaluated on their growth potential and relevant developments that may affect the companies and their performance. According to Mr. Rhame, this enables the fund to be weighted towards those companies which are seen as having the greatest prospects. The intention is for the management to have the flexibility to shift assets as changing situations warrant. The fund would be subject to reconstitution and rebalancing at the discretion of the portfolio manager. Dividends Based on the fund’s current holdings and the dividends paid by those companies, I have estimated that UTES will be paying a little more than $0.61/share . This figure is based on dividend income the fund is projected to receive; the fund could realize additional income in the form of capital gains , interest , etc. The fund should see close to $90,000 in gross income from dividends, giving it a realized yield of 3.22%, based on current NAV. This is in keeping with the average yield of 3.33% amongst its holdings. Given its expense ratio, the fund should see a return on NAV of 2.27%. Mr. Rhame did affirm that the fund would not use derivatives or other instrumentalities (options, shorts) to increase yield. He is satisfied that the approach they are taking will result in greater growth, and he is inclined to invest in those companies having lower yields where it indicates price growth is most likely to occur. He projected yield in the neighborhood of 2.5% , which is consistent with my projections which indicate a yield of approximately 2.31% . Dividends are expected to be distributed quarterly, with capital gains being paid at least annually. 8 Testing the Portfolio As usual, I like to take the portfolio of a new ETF for a “spin,” running its holdings into the past to see how the portfolio might have performed had it been in existence. This “pseudo portfolio” is not used by way of a claim that the results would have been true had UTES been in existence – only that the companies in the portfolio did actually perform in said manner. As usual, past performance should never be taken as an indication of future activity. I ran the portfolio back to 1 January 2005, and seeded it with $10,000. Due to the proprietary nature of the weighting of UTES’ actual portfolio, I opted to weigh the holdings equally. The portfolio was rebalanced every six months. Because utilities are largely used as means of acquiring yield, I ran the test twice: once using the actual closing prices from January 2005 to the present, and once using the adjusted closing price, which reflects a company’s dividends and stock splits for the period covered. 9 The following chart illustrates the portfolio’s performance on both accounts: (click to enlarge) As one can see, there is a marked difference between the return realized in terms of share price alone, and the total returns one would expect once dividends are figured in. The main value in such a portfolio is to be had by holding it for the long term, pulling in the yield, rather than anticipating significant growth of share value. Comparison The portfolio of which UTES is comprised looks to be productive; the question remains whether it is competitive with what is out there now. Besides UTES , there are 10 other ETFs that focus on utilities, 10 with a range of portfolio sizes and offering a range of yields that seem, on first blush, to be superior to that offered by Reaves ‘ fund. For sake of comparison, I have chosen four funds to run side by side with UTES . The funds are: Vanguard Utilities ETF (NYSEARCA: VPU ) iShares U.S. Utilities ETF (NYSEARCA: IDU ) Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) Guggenheim S&P Equal Weight Utilities ETF (NYSEARCA: RYU ) These ETFs were tested using the same procedure as that used for the UTES portfolio. They were run with both the actual closing costs and the adjusted closing cost. The chart for the actual closing cost follows: (click to enlarge) Although the UTES portfolio drops off in the early stages of the trial it comes back to lead the other funds, beating VPU handily by 785bps. RYU has an inception date of 1 November 2006, and that has no doubt adversely affected its comparison in this trial. As one might expect, the ETFs tend to bunch up together (other than RYU ) The following chart represents the adjusted closing price: (click to enlarge) As earlier, RYU’s performance is well back of the other ETFs. IDU , XLU and VPU are grouped together, just as they were in the previous trial – still within about 600bps of each other. The UTES portfolio, however, outperforms VPU by 77 full percentage points (7700bps). The extent to which this is due to the fact that there is no internal loss of income in the portfolio – as is the case with the ETFs – is not clear, although no doubt were the portfolio an actual ETF, its returns would be more than marginally moderated. Some Additional Considerations I asked Mr. Rhame directly how he thought their active management of UTES would set it apart from the passive funds it competes against. His response focused on the fact that Reaves was in a position that enabled them to put their experience to work. They were familiar with the issues facing various companies, the effectiveness of companies’ management, and the prospects each company had. As examples of their ability to put their knowledge of companies to use, he cited the following: Atmos Energy Corp. (NYSE: ATO ): This company is involved in the gas pipeline business. One of the largest natural-gas-only distributors in the U.S., and located in Texas, Atmos is involved in a long-term pipeline replacement project that assures the Company of regular rate increases to cover its costs. On 4 November 2015, the Company announce it would raise its dividend by 7.7%, to $1.68 from $1.56. 11 DTE Energy Holding Co. (NYSE: DTE ): Located in Detroit, DTE is one of the best-managed utility companies in the country, according to Mr. Rhame. The Company is one of the largest employers in Detroit, and is heavily involved in efforts to revitalize the city. The Company is committed to keeping its utility costs low; its efforts are recognized and supported by the Michigan state government. Both companies are in the fund’s portfolio ( DTE is the fourth-largest holding). Mr. Rhame also expressed Reaves’ commitment to making UTES completely transparent , a concern many investors have when considering actively managed funds. I do have some reservations about the yield UTES seems positioned to offer. A yield of 2.31% (if my estimation is correct) is significantly lower than that offered by other ETFs. Growth prospects would have to be pronounced if they are to compensate for the lower dividends. Of course, the primary influence on how much of its income a fund is able to distribute to shareholders are the fund’s expenses. The following graph shows how the funds in the graph above compare in this regard: [*Note: again, I must point out that dividend figures for UTES are my projection, and discussions thereof must be considered in that light.] Clearly, the premium exacted by UTES takes a toll on the dividends it is able to pay out; the expenses for actively managed funds is, as a rule, higher than that of passive funds, and UTES is on the lower side of active funds. Key to UTES success, again, is going to be whether the active management justifies its higher costs by bringing value into the fund. If that value is not going to be in the form of dividends, it will have to be by virtue of the value of the shares in its portfolio – either UTES will have to grow in value or it will have to return substantial capital gains to its shareholders. One last point needs to be made. Utilities tend to have high debt-to-equity (D/E) levels; on the whole, utilities as a sector have an average total-D/E of 1.55 , up noticeably from the average of 1.42 for the past three quarters. 12 The companies currently held by UTES have an average D/E of 1.20 . No doubt regulatory controls influence the level of debt these companies have, and Reaves’ strategy of focusing more on the infrastructure-related companies, which may encounter less regulatory influence than power-related companies, is a good one. Assessment I think it is clear that UTES has the potential to be a very profitable holding; however, the difference between it and other utilities ETFs is going to rest on the ability of its managers to effectively populate its portfolio with stocks that increase in value . The dividends to be realized from the fund will be good, but may not be as good as those offered by other utilities funds. Given Reaves ‘ extensive background in tracking the utilities sector, I am confident that this would be the right group to manage a portfolio on a day-to-day basis. Their current portfolio reflects a choice of holdings that have noteworthy potential . It might serve well to give this ETF a few months as a sort of shakedown before buying, and then buy shares gradually. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from Yahoo! Finance . Data from any other sources (if used) are cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. I would like to thank Mr. Rhame for kindly providing his view of UTES. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. ————————— 1 The Yield Hunter on utilities . 2 Data in the table includes projections that are based on my research into UTES and its holdings. In particular, income and dividends/yield are my projections based on dividend income I project UTES to receive from its holdings. Income yield (Inc. Yield) is reached by dividing gross income by NAV; return on NAV (RoNAV) is determined by dividing net income by NAV. Expense margin represents the portion of income that is left after expenses are subtracted from gross income. The fund’s website is here . 3 I spoke with Mr. Rhame by phone on 21 October 2015. All mentions attributed to Mr. Rhame refer to this call. 4 Prospectus, Reaves Utilities ETF ( UTES ), p. 4. 5 Many of the funds’ holdings are multinationals headquartered in the U.S. 6 Prospectus , p. 4. 7 Prospectus , p. 4. 8 Prospectus , p. 12. 9 I need to make a qualification here. The returns realized from the perspective of a portfolio of holdings, each one paying dividends directly to the portfolio holder, will be larger than the returns one would realize from an ETF, where dividends are paid to the fund’s management who then covers expenses with that money, distributing the remainder to the fund’s shareholders. With this in mind, I need to point out that the returns from the portfolio being considered is perhaps significantly higher than the returns from UTES would be. 10 Two of the available funds are leveraged “ultra”-style ETFs. 11 This is also the 28th consecutive year in which the company has increased its dividend. Atmos press release . 12 Data from CSIMarket.com .

How To Optimize Warren Buffett’s Asset Allocation Advice

In Berkshire Hathaway’s 2013 annual letter to shareholders, Warren Buffett gave some retirement savings advice to investors. The Oracle of Omaha wrote in his letter to shareholders that he had given the trustee designated to manage the bequest his wife will receive, the following advice: “What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit … My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” Buffett’s advice sparked a debate in the financial community. Many market commentators asked if this really was the most sensible asset allocation approach for retirees, or indeed any investors at all. Javier Estrada at the IESE Business School, Department of Finance, Barcelona, Spain set out to answer this question in a paper titled, “Buffett’s Asset Allocation Advice: Take It … With a Twist”. In particular, the paper set out to answer the following question: “Is the asset allocation Buffett advised for his wife appropriate for other investors? If yes, why? If not, why not?” The study considers several different variations of Buffett’s recommendation. Eight static asset allocations with varying stock/bond proportions are evaluated, with particular attention to the 90/10 split suggested by Buffett. A further two minor dynamic strategies are also considered with valuation based twists. What’s more, the study is designed around the needs and skills of the average retiree. For example, the dynamic strategies are trivial to implement, and the person managing the portfolio will only need information about the performance of stocks, or that of stocks and bonds, over the previous year, which is publicly and widely available. Asset allocation: Data The data used for the study is based on the two asset classes suggest by Buffett, stocks, and short-term US Treasury bills. Returns are annual, adjusted for inflation and account for capital gains/losses and cash flows. Over the 114 year period considered, from 1900 to 2014, stocks and US T-bills had mean annual compound real returns of 6.5% and 0.9%, with annual volatility of 20.0% and 4.6%. The test portfolio was rebalanced once a year and the study assumes an annual withdrawal is made proportional to the asset allocation. The analysis is based on an initial capital balance of $1,000, an initial withdrawal of 4% of the capital and subsequent withdrawals annually adjusted for inflation over a 30-year period. Asset allocation: Results The chart below shows the results of the eight static portfolios over the period studied. (click to enlarge) Asset allocation results Figures indicated that strategies with equity holdings between 100% and 40% have similar failure rates, but when the allocation of stocks rises above 30% failure rates increase considerably; to above 10% in most cases. Although there are varied opinions regarding what is an acceptable failure rate, most practitioners seem to agree that failure rates below 5% should be viewed as acceptable by most retirees. Upside potential is measured by the mean, median, P90, P95, and P99. Downside protection is measured by both P5 and P10. The author concludes with test with the observation that: “…although the 60/40 strategy never failed, the 100/0 and 40/60 failed 3.5% of the time, and Buffett’s 90/10 failed 2.3% of the time, there does not seem to be a substantial difference in the failure rates of portfolios holding at least 40% in stocks.” “…as far as static strategies is concerned, Buffett’s suggested allocation has a very low (although not the lowest) failure rate; a very high (although not the highest) upside potential; and provides very good (but not the best) downside protection when tail risks strike. Put differently, Buffett’s suggested allocation seems to provide a middle ground between the best performing strategy (100/0) in terms of upside potential and the best performing strategies (60/40 and 70/30) in terms of downside protection.” Adapting Buffet’s advice Javier Estrada goes on to look at two different dynamic asset allocation strategies, which are based on the static strategy recommended by Buffett, but with a few changes. The first change [T1] relates to the annual withdrawal to the behavior of the stock market in the previous year. If stocks have gone up, the retiree takes the annual withdrawal from stocks and then rebalances the portfolio back to the 90/10 allocation. Conversely, if stocks have gone down, the retiree takes the annual withdrawal from bonds and does not rebalance the portfolio. The second change [T2] relates the annual withdrawal to the relative behavior of the stock and bond markets in the previous year. Just like adoption above, if stocks have gone up in the previous year, (more so than bonds) this change calls for the retiree to take the annual withdrawal from stocks and then rebalances. However, if the returns from bonds have exceeded those from stocks over the previous twelve months, the retiree takes the annual withdrawal from bonds but does not rebalance. (click to enlarge) Asset allocation results As the author observes, results of the two twists considered are very similar. T1 has a slightly higher overall upside potential, and T2 provides a slightly better overall downside protection. Both T1 and T2 outperform the 90/10 allocation. Although, the three strategies have the same failure rate (2.3%). T1 and T2 provide retirees with both a higher upside potential (as measured by the mean, median, P90, P95, and P99) and better downside protection (as measured by both P5 and P10) than the 90/10 allocation. Conclusion Overall then, Buffett’s asset allocation advice is sound and simple. However, for those retirees that are concerned about holding such an aggressive portfolio, the two aggressive strategies may offer better returns. The author of the paper concludes: “…the two simple twists considered here improve both the upside potential and the downside protection of the 90/10 allocation. These two twists require retirees neither to collect vast amounts of information nor to make any valuation judgments but only to observe the performance of the stock market, or the relative performance of the stock and bond markets.” “Either way, retirees can, with little effort, improve upon the results of the 90/10 allocation. In fact, because the performance of the two twists considered is so similar, retirees may want to lean towards the first one (T1) and simply adjust their asset allocation according to the observed performance of stocks.” “…those retirees that find a 90/10 portfolio acceptable are likely to find that with an insignificant additional effort, observing the performance of stocks and implementing the first twist discussed, they are likely to improve the performance of their portfolios.” Rupert may hold positions in one or more of the companies mentioned in this article. You can find a full list of Rupert’s positions on his blog. This should not be interpreted as investment advice, or a recommendation to buy or sell securities. You should make your own decisions and seek independent professional advice before doing so. Past performance is not a guide to future performance.

Alliance Resource Partners: Circle Of Competence In Action

Summary The concept of a circle of competence is probably more important to avoiding risk than anything else, but it is not discussed enough in context. Coal is obviously hated right now. I can’t think of anything more universally hated. That can mean opportunity. And Alliance’s track record is incredible. Just looking at the financials, you would never guess that this is a commodity company. But I don’t understand the legal/regulatory environment and the price of coal in the Illinois Basin has declined to a point that implies breakeven EBITDA for ARLP. Circle of competence is probably the most important concept in investing for avoiding catastrophic risks. Most people can understand some businesses, but everyone has many businesses they do not understand well enough to touch at any price. Understanding can be changed. You can learn, but that should be done before making investment decisions regarding the businesses you don’t understand. Circle of competence gets a lot of attention among value investors, but still not as much as it deserves, and where it is discussed, it is usually abstract because no one wants to discuss specific things they don’t understand. It’s tough on the ego. That’s exactly what I’m going to try to do here. Coal I don’t understand coal. Alliance Resource Partners LP (NASDAQ: ARLP ) came up on my list of low EV/EBIT stocks. To this point, I’ve been dismissing MLPs entirely, but I decided to give this one a chance. This is important because I’ve never invested in an MLP before, so there’s already a layer of non-understanding here. The MLP issue is not the crux of it. It looks like MLPs are publicly traded limited partnership interests. Only companies in certain industries like commodities can structure as MLPs. They aren’t taxed at the corporate level, and distributions (not “dividends”) are return of capital – they lower your cost basis but are not taxed immediately in most cases. When you sell, your capital gain (hopefully you have a positive total return) is taxed at your ordinary income rate, not at capital gains rate. You should always own MLPs in taxable accounts because they are actually taxed preferentially there compared to in a tax-exempt account like an IRA. Great, so maybe I could own an MLP. But coal is another story. Coal must be one of the most, if not the most, hated industry out there right now. The industry ETF (NYSEARCA: KOL ) is down almost 50% over the last 12 months: (click to enlarge) Environmentalists hate it because it produces more CO2/energy produced than other energy sources. Coal produces 2000 lb of CO2 per ton, while gas (natural gas is its closest competitor) produces 1100 CO2. The government hates it because environmentalists hate it and environmentalists are voters. There are also reasonable negative externalities but I’m trying to be pragmatic. Investors hate it because the stocks have been killed to the point where it’s tough to be an institutional investor and hold anything related to it. Utilities hate it because its controversy is causing them to spend billions converting electric power plants to gas-powered and other energy sources. Kids hate it because it’s what they unwrap on Christmas instead of the things they actually wanted or could do anything with. I may or may not be able to keep going, but you get the point. My insight was that there might be a market prejudice in all this hate and maybe there is opportunity in the pessimism on coal. Alliance in particular looked interesting. Despite being a cyclical, commodity business, the financials look really interesting. Operating income has been positive every year over the last 10 years, and substantially so with OM% never getting below 13%. FCF conversion from EBIT has been about .6x, unheard of in my experience for a commodity business. Book value per share has compounded from 1.68 to 14.16. Revenue has grown every single year. The share count has not been diluted at all… Just unusually fantastic long-term numbers. (click to enlarge) And the stock price has done well long-term: (click to enlarge) There’s a really informative post from Value Investors Club that perfectly laid out the bull case on the stock. It’s quite compelling. The company has been led by Joe Craft since the mid ’90s and he’s been with the company since he left college around 1980. He owns a substantial interest in both the GP and ARLP and is thus properly incentivized. He only takes a salary of $700k/yr. Apparently, ARLP is a low cost producer generating some 95% of its coal in the low-cost Illinois Basin. I don’t know much about commodities, but I know being the low-cost provider is everything in terms of competitive dynamics. ARLP stock now trade at an EV/FY15 est. distributable cash flow of like 4.3x. And a third of that EV is debt. In other words, they could hypothetically pay a ~33% distribution. This all sounds great, except that there are many things I just don’t understand about coal. One is regulation. According to John Huber , there is regulation in the works that could force utilities to move away from coal: Adding to the cyclical woes are the regulatory hurdles that the industry currently faces, and will likely continue to face going forward. The US Supreme Court remanded the EPA s Mercury and Air Toxic Standards on June 29th , which would have cost power plants upwards of $10 billion annually. This was perceived as a victory for the coal industry, but many power plants have already been converting from thermal coal to natural gas in anticipation of regulatory requirements. Who knows what lower courts will decide regarding mercury emissions, but once a plant switches to gas, it’s not going back to coal regardless of price. Then there is the unrelenting decline in coal prices. In the Illinois Basin in particular, coal prices have declined to a point that implies breakeven EBITDA for Alliance: (click to enlarge) Source: Quandl / US Energy Information Administration . I don’t know how their margins will hold up given that. The current 20% operating margin seems unusually high for a commodity company. Maybe ARLP will even lose money this time around. I just can’t get comfortable with this. I’m using too many “maybes.” Even if ARLP is attractive now on an expected value basis, without a great deal of knowledge, there’s no way for me to say with any degree of certainty in the face of declining coal prices that my downside is limited. And that’s a requirement for my portfolio. I may do further work here, but for now coal and ARLP are getting put in the “don’t understand/too hard” pile. Hopefully this not only provides some information about coal and ARLP, but serves as an example of the circle of competence concept in action.