Q: What is the history of the fund?
The Gas Utility Fund started as a collaboration between the American Gas Association (AGA) and an investment advisor in Bethesda, Maryland. The AGA is a non-profit industry lobbyist and focal point in Washington, D.C. for natural gas distribution companies. The Fund was formed in 1989 with about 125 publicly-traded Local Distribution Companies (LDCs) around the country.
In 2001, the original investment advisor sold the Fund to FBR & Co. which was then acquired by Hennessy Advisors in 2012. At that time, Ryan and I became employees of Hennessy Advisors. I have been the Fund’s portfolio manager since2001, and Ryan joined about four years ago as co-portfolio manager.
Today, the Hennessy Gas Utility Fund is one of 14 Hennessy mutual funds. The intent and purpose of the Fund is to provide investors the return less expenses of the AGA Stock Index, which is owned and maintained by AGA. In addition, AGA provides us access to the industry and information on the industry’s companies. Hennessy Advisors has exclusive rights to the index.
Q: What core principles drive your investment philosophy?
Every energy segment (e.g. oil, coal, natural gas) can be divided into two major components – exploration and production (E&P) and distribution. The Hennessy Gas Utility Fund is focused primarily on the distribution side of the natural gas segment of the energy business. Natural gas has become the major energy source for power generation and residential heating and cooking in our country, due to its availability and supply, and its environmental benefits over other fossil fuels.
Q: What is your investment strategy?
The fundamental thesis is that an abundant supply of natural gas leads to low and stable prices and increased consumption. With increased consumption, more and more natural gas moves through the distribution system, producing more revenue for those companies associated with natural gas distribution. The increased revenues should lead to higher profits, increased dividends and hence higher stock prices.
Since our objective is to provide the return of the AGA Stock Index less expenses, we don’t pick companies, we invest in the companies of the index. We own the companies that are in this index in roughly the same weighting as the index, resulting in obtaining the return of the Index.
Our investments are market cap weighted. They also are modified by the amount of a company’s business tied to natural gas. As an example, one of the most unusual companies we hold in the Fund is Berkshire Hathaway, Inc. They have a North American subsidiary involved with natural gas distribution, which is why they are a member of the AGA. Normally, with their market cap they would be one of our largest holdings. But since their natural gas exposure is a minor part of their overall business they are less than 0.5% of the portfolio.
Q: Why do you focus on the natural gas distribution business?
The natural gas distribution business has inherent growth characteristic tied to the abundant U.S. supply and environmental benefits. The industry has shown consistent growth in revenues, profits and distributions, which has resulted in consistent investment returns.
Another unique growth factor tied to this industry occurs with the capital expenditures used to modernize the distribution infrastructure (e.g. replace aging pipelines) Utility companies are spending billions of dollars to replace old cast iron pipelines with new PVC ones. They are encouraged to invest this capital by the regulators and are rewarded by being able to have it be accretive to earnings. Customers are rewarded by having a safer pipeline system. A win win.
Q: What other factors influence your strategy to invest in the natural gas industry?
There are two major natural gas consumption drivers – residential heating/cooking, and power generation. Ten years ago, 45% of all electricity was produced by coal-powered plants with an average age of 45 years, built in a time when coal was readily available and cheap – and no one was concerned about CO2 emissions. Now we understand that burning coal emits gases that can be harmful to the environment. This has led power companies to replace, repair and rebuild older plants to be more efficient, by either putting on a lot of pollution controls or looking at a new source of energy, like natural gas – which today produces 35% of our electricity. Coal as fuel has dropped to about 30%.
Green power plants have an economy of scale problem. To produce the same amount of power as a 600-700 Megawatt plant, you would need almost 100,000 acres for a windmill or solar farm. Since we have 700-800 power plants, the land mass needed to replace all these plants with green sources is currently prohibitive. All these factors ultimately lead to natural gas as the energy fuel of choice for power generation for the foreseeable future.
Q: Do interest rates affect your fund?
We have found there is statistically no correlation between the performance of the Fund and interest rates. The biggest reason is that the underlying industry that the Fund invests in, natural gas distribution, has been a growth industry. This growth has generally overridden any negative influence from periods of rising rates. As an example of this growth, for the last 10 years, in the United States, we have used about 3% less energy, but the use of natural gas has gone up 25%. This industry has benefited from that.
The Fund is a total return investment, comprised of dividend return and appreciation return. And yes, dividend returns can be sensitive to interest rates. But the appreciation return is tied to the underlying industry that the Fund invests in. It is the growth of the natural gas distribution industry that has driven the performance of the Fund.
Q: How do you construct your portfolio?
We tend to invest about two-thirds of the portfolio in natural gas utilities or diversified electric utilities that have a natural gas distribution subsidiary. The remaining one-third of the portfolio is comprised of pipeline/interstate pipeline companies. We include all market caps, from the very large over $20B to the relatively small, less than $100 million. No single company is greater than 5% of the portfolio by design. The smallest holding is less than 0.03% of the portfolio.
We also want to minimize shareholder expense. As money flows in and out of the fund, we need to raise cash or use cash, which causes us to trade. We don’t automatically buy or sell every holding. On an average day we may buy or sell 4-6 holdings to align the portfolio with the index within various tolerance levels. This allows us to stay closely balanced to the index.
Our turnover ratio right now is about 34% and that is quite high versus the past. A lot of that is because of mergers and acquisitions (M&A) and new companies that are coming into the Fund, as well as some shareholder activity. A lot of international companies, primarily Canadian, have come in over the last 18-24 months, and we’ve picked up some LDCs or small diversified utilities. National Grid, PLC, a United Kingdom company, is in the Fund, and they have purchased U.S.-based utilities.
A recent example of M&A activity was Southern Company, a large coal-based utility in the U.S. As it converts from coal to natural gas, they want to have more control over distribution, so they acquired AGL Resources. We have seen 30%, 40%, 50% stock appreciation as these deals are announced, so that is added to the returns of the Fund.
We are not the decision maker on who is in the index, a stock’s weightings, or percentage allocation. This is all done by AGA. Hence the Fund is what is called passively managed. We primarily manage the process to ensure the Fund’s objective is met and provide shareholder liquidity.
Q: What do you mean by key drivers for demand? Can you elaborate on that?
Key drivers are those issues that would increase demand for natural gas and benefit the Fund’s holdings. We have talked about power generation and residential use, but another key driver is the exportation of natural gas. Canada and the U.S. have a vast amount of resources, whereas Mexico, Central America, Latin America, etc., do not. Also, Asia and India have extremely large populations and are growing energy consumers. And Europe relies on a vast interconnected pipeline system to provide natural gas around the continent, primarily controlled by Russia.
Finally, another growth factor is using liquefied or compressed natural gas to fuel cars, trucks, buses and other transportation uses. With the recent decline in oil prices; however, this driver has taken a back seat to the others above. But whenever gasoline and diesel prices rise, this driver should become more important.
Q: How is risk allocated and managed in the Fund?
We try to use common sense. In 2000-2001, it became clear that Enron was headed towards an ultimate demise. We are free to deviate from weightings and other methodologies to make rational decisions if we think there is a pending bankruptcy or something that could harm shareholder interest. We did that with Enron, and are free to do that again, but it would be a rare occurrence.
I think the 5% limit on the holding size is a good risk diversifier control. The Fund historically has held roughly 1% or less in cash. We do have an ability to go to a temporary defensive higher cash position if needed.
We also review liquidity if we see some higher cash demands or redemptions. So many of these names are mega-cap companies with plenty of trading volume. But for those that are thinly traded, we try not to move their stock price with our orders.
We invest only in the common stocks of the companies, not preferred stocks or bonds.
Of the 54 companies in the portfolio, our maximum holding size is 5%. We have very little exposure to actual Exploration and Production (E&P) side of the natural gas business. We do have some international exposure, which is primarily from diversified Canadian utilities.
Q: What does the new administration mean for the industry?
There seems to be a freeing up of regulatory issues, initially in the pipeline side of the business, to promote the industry and create jobs. We anticipate this to continue. We’re also watching what happens concerning the Environmental Protection Agency’s (EPA) regulations regarding power plant emissions.
The President has been very vocal about trying to help the coal industry, but I don’t see consumers going back to coal. We could see an increase in exporting coal to countries like China and India to meet their voracious appetites. We believe natural gas will continue to be the fuel of choice here in the U.S. for power generation.
Q: What is the flip side of investing in natural gas distribution companies?
Natural gas is an explosive, combustible fuel, so safety is a primary concern. In older communities, the pipeline system is 100 years old, and the EPA has put a “Call-to-Action” to replace these pipes. There also is a lot of money being spent on cyber security.
Q: Do natural gas price fluctuations impact your investment strategy?
On a short-term basis, the two largest commodity price drivers are weather and the economy. We will see spikes when we have abnormal weather. There was the 2001 cold snap, and we had a spike in prices. During the 2008-2009 financial crisis, there was a commodity price run up, not just in natural gas, but crude oil as well.
Then we entered the “Shale Era,” – hydraulic fracturing and horizontal drilling to extract natural gas. Now we have over 100 years of natural gas readily available.
So, from 2010 on we have been in a band of about $2.00 to $5.00 for a million Btu of natural gas. We did have a very cold winter in 2014, causing natural gas to spike, but prices have steadily declined and currently hover around $3/million Btu.
When prices run up, we put more rigs to work and produce more natural gas, the price starts to come down and the rigs stop drilling. This is the wonderful law of supply and demand. And of course, the state of the U.S. economy can affect the cost of the commodity on a long-term basis.
Generally speaking, a lower price of natural gas is a positive for the Fund. Low commodity prices tend to drive higher demand and consumption, which tends to benefit the distribution-focused holdings of the Fund.
