In June 2012 James Smith was appointed as investment manager at Premier Energy & Water Trust (PEW) where he immediately set about repositioning the portfolio. The results have been good: between July 2012 and May 2014 the portfolio returned 44 per cent, and instead of making returns in line with the FTSE All World Utilities Index the trust has been significantly outperforming it.
"We had a good run down of the portfolio and sold a lot of it," says Mr Smith. "At Utilico (where he worked previously) I spent most of my time on the emerging markets side and this is reflected in the fact that Premier Energy and Water Trust now is much more focused on this region."
Emerging markets allocation has increased from 37 per cent at the trust's final year end before Mr Smith started running it to almost 58 per cent in June this year.
Investments purchased include Indian electricity company OPG Power Ventures (OPG) which Mr Smith says has risen around 90 per cent since they started buying it for the trust. He first paid around 33p and now the company trades at around 99p. The company had a particularly strong first half of 2014 with its share price increasing 75 per cent.
"OPG has a different structure to other Indian power companies," he says. "It can import coal and the international costs of that have come down. OPG has smaller power stations near to the sea so it doesn't rely on domestic coal production. Other Indian companies tend to build power stations where the coal is to cut transport costs. But they have been slow to get permission to mine it, and as they are inland it is hard to import it.
OPG's share price got marked down because of sector problems that didn't apply to it. We have taken a big bet on it but have got it right so far and expect it will continue to generate value next year."
OPG is commissioning two new power stations which should lead to a change in earnings and value. It is the Premier Energy and Water's largest holding, accounting for 9.5 per cent of assets.
Waste incineration company China Everbright International (257:HKG), meanwhile, did very well in 2013 so Mr Smith reduced his holding early this year on valuation grounds. "It is still a great company but we bought it on a low double digit multiple whereas now it is on a price-earnings ratio of about 25x," he explains.
The proceeds from reduction of China Everbright and two other holdings, China Suntien Green Energy and Kunlun Energy, have been largely reinvested in the Chinese thermal generation sector, with two new entries to the trust's top ten holdings, Huaneng Power and China Power International. They account for 3.8 and 3.9 per cent of assets respectively.
These investments performed well over the first half of this year with Huaneng Power rising 24.8 per cent and China Power International rising 10.9 per cent. "The expansion of Chinese coal mines over many years is now leading to a surplus of coal as gross domestic product (GDP) growth slows," says Mr Smith. "This has resulted in expanding margins and earnings for the generators as their costs fall."
The slowing of GDP has meant lower energy usage meaning demand for domestic coal is stagnant resulting in this commodity being cheaper.
China is Premier Energy & Water's largest geographic exposure accounting for a fifth of assets.
Mr Smith also likes UK regulated utilities such as SSE (SSE). Utilities fall into two broad categories - regulated and unregulated. "We prefer regulated utilities because it is the only sector where you get a genuine monopoly," he says. "Last year we sold Centrica (CNA) because it is a competitive business. SSE is mainly regulated with some competitive areas and has done much better. UK infrastructure is also largely under invested and SSE builds transmission wires: for example, it has built infrastructure for transmission of green energy from Scotland to England."
As an investor you are constantly being told to diversify your portfolio, so why invest in a fund that is focused on utilities?
"The past few years have been rough but long-term utilities do well," says Mr Smith. "Regulated utilities in particular are very defensive and pay high dividends, and over the long-term stocks make most of their return from dividends. And this trust is well diversified sectorally and geographically."
A problem for UK investors investing abroad has been the strength of Sterling, which the trust says will be to the detriment of the level of income. However, Mr Smith says the strength of underlying dividends mitigates this, so it is generally their policy not to hedge.
Risks to investing in listed utilities include regulation and politics, but this is not necessarily higher in emerging markets. Developed markets present economic risks because of debt problems, "and every government in the UK seems to change energy policy," he adds.
UK demand is also generally flat or falling because the country is becoming more efficient. "But if a country's GDP is growing then the energy surplus falls, so regulators have to offer tariffs to incentivise power companies to invest. Emerging economies need to keep the supply base growing."
Investors in emerging markets face corporate governance risks but Mr Smith says that with many large state-owned companies, such as some utilities are, there is less scope for fraud - and they are simple to audit. "We prefer companies with physical, regulated assets," he says. "We meet their managers and make site visits, and I go through their accounts in a great deal of depth: it helps to take an accounting approach when you look at cash flows. If a company pays a good dividend year in year out, it is likely to be a good business producing money. And we have a fairly concentrated portfolio so know our companies inside out."
The trust has 45 holdings and the top 10 account for 44 per cent of assets.
Going forward Mr Smith would like to grow the size of the assets, which should be possible as shareholders recently voted to continue the trust until at least 2020, rather than have a continuation vote in December 2015. Alongside the trust's holdings in highly liquid, large utility companies, it also holds smaller companies which are less easy to trade.
"The timeframe over which we expect to realise value from these positions extends well beyond 2015, and the proposals offer shareholders the opportunity to participate in the potential upside that we believe exists in these investments," says Mr Smith.
