Skip Aylesworth: I’m here today to talk about the Hennessy Gas Utility Index Fund, which is a fund that’s been around for almost 25 years. It was formed in 1989. And since that time, it’s had just two portfolio managers. I’m the second and took over in 2001.
It is an index fund comprised of 64 public companies that are involved in the natural gas distribution business. The fund is about $950 million in size. 62 out of the 64 companies in the fund pay a qualifying dividend, under the current tax law. The current yield of the fund is about 2.5% to 3% depending on the Fund’s closing price on any given day. Its performance over its life has been quite good. We’re very fortunate in that we’re involved in the natural gas industry, which has had a tremendous run in terms of stock price for the individual companies. Hence the fund has done well.
For various time periods, one, three, five, ten, 15 years, we’ve been in the top quintile of performance as per Morningstar. The fund has beaten the S&P for all those time periods. Its annualized return since inception is about 10%. Roughly a third of that return is dividends oriented and two-thirds appreciation. It has a low beta and it has a positive alpha.
It’s a great winning combination for a fund so that it can be used as an asset diversifier. Many people use this fund as an asset diversification technique to lower their risk in the overall market. What makes this fund so good? It is fortunate to be in a particular industry that’s has enjoyed a renaissance and has had a very good run. But let’s talk about the specifics of this fund which is an index fund and about the index methodology we use.
Forbes: I think that would be very helpful in order to get a sense of how you’re building the fund.
Aylesworth: The Fund is an Index fund that tracks an Index maintained by the American Gas Association, known as AGA. AGA is a non-profit organization for the distribution side of the natural gas industry located in Washington DC. In their index, they have all their members that are publically traded on an American exchange.
Currently there are 64 public companies in the American Gas Association. The methodology for actually weighting the index is a modified market-cap methodology. Basically they take the stock price times the number of shares and then multiply that by the percentage of the balance sheet of each company that is devoted to the natural gas industry.
This modifier allows the Index to take into account and adjust the weightings for Index components that have diversified revenue streams. Many member companies are normal utility companies that produce electricity and deliver natural gas. We multiply by the percentage devoted to natural gas, so that they don’t overweight the index from components that are not in the natural gas business.
Forbes: Well, that’s very helpful and makes a lot of good sense to do it this way so that you’re talking about natural gas and don’t include all their other activities.
Aylesworth: Well, you still have a risk from these diversified revenue streams, because it is a diversified company, but it is reduced. And also, AGA limits any one company to not being greater than 5% in the index. What this tends to do is take the super big companies and reduce their weightings and increases the weightings of the smaller companies. In effect, it’s a modified market-cap weighting of the index.
Forbes: If some of the companies would be in excess of 5%, how do you distribute the excess among the other companies?
Aylesworth: You spread it across the other companies based on their weightings.
The objective of the fund is to provide a return that correlates with this index. There are generally two ways in the investment community to do that. One is to use derivatives. We do not use that approach as it has its own risk issues. And the second way is to do a replicative approach, which basically is to own all the stocks that are in the index in their Index weightings. By using this approach simple math wins out and you achieve the fund’s objective. So we think that’s a more conservative way than to buy a derivative product to get that return. So we own all 64 companies and we own them in roughly the same weightings that are in the index.
The end result of all this is that this portfolio is very representative of the distribution segment of the natural gas business. The natural gas business is divided into two major components. There are the drillers that look for natural gas. That’s known in the industry as E&P — exploration and production. The second major component is the distributors. They’re the pipeline companies, the storage companies, the local gas companies that connect to your house, and also the L&G liquid natural gas companies. It’s these types of companies that are predominantly in this fund. The American Gas Association is basically their non-profit organization in DC that maintains and controls the index.
So there’s a methodology that leads to how we get to own what we own, why we own it, and why we own certain percentages of what we own.
Forbes: So am I right in understanding you don’t make decisions as to particular stocks that you like or otherwise. You are distributing your investments across the industry?
Aylesworth: Correct. As a portfolio manager, my job is primarily to manage the process, not to investigate and hand pick individual investments. So when the money comes in or the money goes out, I’m making adjustments to the portfolio. I don’t buy all 64 stocks every day or sell 64 stocks. But I always try to keep it within a certain balance, and that’s primarily my job.
Forbes: Do you have any individual stocks that you as an investment analyst have an opinion on? I would like to hear what some of those favorites might be.
Aylesworth: This industry now seems to have a very positive outlook. What are some pretty good stocks that investors may want to look at? There are some major themes that I’ll describe and then the individual stock that I would pick to fit those themes.
Aylesworth: The first theme I would pick is the pipeline and the distribution part of the major interstate pipeline system. Historically, investors invest in that through Mastered Limited Partnerships (MLP, a type of limited partnership that is publicly traded). But what’s even better than to be a limited partner in a Mastered Limited Partnership is to own the general partner of the Mastered Limited Partnership.
You know, kind of a rule your Dad told you: “It’s always better to be the general partner than the limited partner.” So this fund has within the portfolio many general partners. And the one that I will pick for today’s conversation would be ONEOK Inc. (NYSE: OKE). It’s located in Oklahoma. It is a diversified, distributor of natural gas. This means it does numerous things in the distribution business. It is the local gas supplier in Oklahoma. If you live in Oklahoma and you connect gas to the house, ONEOK will be your utility. And they are also involved in major interstate pipelines.
What makes it unique is that it is the General Partner to the Mastered Limited Partnership. As an example, when the MLP raises its dividend let’s say 2 cents, the general partner normally gets like 10 cents. So by contract, the general partner normally will pull off a higher percentage of profits. Hence the General Partner will normally be a better investment particularly if its MLP does well. Hence, the General Partner is really a great thing to own. Now, the fund owns several. And there are several great examples. But ONEOK is the one that I’m suggesting today.
Aylesworth: Another theme in the natural gas business is liquid natural gas, LNG. We are all familiar with the natural gas that we connect to the house for heating or cooking. However, if we super cool it under high pressure, it forms a liquid (LNG) and we’re then able to ship LNG via tanker around the world.
Now, why is this becoming important? The US now has great resources of natural gas in our country — roughly 100 years of supply. So exporting LNG is a business opportunity. And the reason it’s a business opportunity is that the price of natural gas in our country today is roughly $4 per million BTU. That’s the common unit. Now that price in Europe is $10 or $12 per million BTU. And in Asia, it’s $16, $17, $18 per million BTU. So there’s a large gap and a large profit potential that a capitalistic society would like to go after. LNG exporting is how this would be done.
Forbes: Sound good to me.
Aylesworth: We have a lot of natural gas. So exporting natural gas is becoming a business that is attractive because of these pricing differentials. And to get into that business, you have to have export facilities. You need the facility that will super cool the natural gas, and you need a port.
Now, the fund has two companies that are involved in this business. The one company that I’m going to suggest today is called Dominion Resources Inc. (NYSE: D). Dominion is a diversified utility. They produce electricity. They’re the local gas distributor. They have pipelines. But they also own an LNG port, and have gotten a license to export LNG and, starting next year, they will be exporting LNG around the world. The second company we have is called Cheniere Energy Inc. (NYSE: LNG), which is a great symbol since it’s 100% devoted to importing and exporting LNG. That’s all they do. But Dominion is diversified. And I think that’s a little bit more conservative way to play this relatively new business.
Another theme in the fund is what I call the Canadian theme. And the two largest natural gas pipeline companies and producers and electricity companies in Canada are in the fund. One is called Enbridge Inc. (NYSE: ENB). They’re the largest pipeline company in Canada. Primarily they bring a lot of natural gas into our country from Canada and from the large Canadian resources in Alberta. The second major Canadian company is TransCanada Corp. (NYSE: TRP). It not only is a large pipeline company, but they also produce a lot of the electricity in Canada. And they’re the firm that’s involved in this Keystone Pipeline that you hear about in the news in our country. Keystone is a pipeline to bring natural gas and oil from Canada down to the Gulf Coast.
Forbes: If it ever gets approved.
Aylesworth: Yes, if it ever gets approved. But of those two companies, I’d probably pick TransCanada as perhaps a better short-term investment. They’re both terrific investments but TransCanada’s has not moved as much in the recent months because of the Keystone exposure. As that gets resolved, and I trust it will, TransCanada should do quite well. Enbridge has done quite well, and I suspect will continue to do so. Both are in the fund. Those two companies comprise 10% of the fund. So they are a big piece of why the fund has done well.
Forbes: They’re up to the caps for the fund on each one?
Aylesworth: They’re up to the caps. Now, the last stock I will mention is a small cap, because everybody always likes to hear about small cap companies thinking that they might be subject to buyouts, dividend increases, et cetera, et cetera. So I have a very small company that I think people might be interested in. The company is Corning Natural Gas (NASDAQ: CNIG). It is located in Corning, New York.
It is the local gas company in Corning, New York. If you live in Corning, and you heat or cook with natural gas, Corning Natural Gas is connected to the house. But what makes it a kind of unique play is its geography as it is immediately next to the Marcellus shale deposits. Marcellus shale is where a lot of the new found natural gas supplies have been found. There’s a tremendous amount of natural gas in this area. And it’s in central to western New York, northern Pennsylvania.
But what makes Corning interesting; it is kind of like the gatekeeper for the gas from Marcellus shale into the major pipelines that bring the gas to New York City. So it’s kind of like the toll taker just by geography, not necessarily the industrial base of Corning, New York.
Forbes: Got you.
Aylesworth: But by its geography and by its pipeline system, it will have a major role in connecting the gas deposits of the Marcellus Shale (SIC) into the major interstate pipelines that run throughout central New York.
Forbes: Those are great, Skip.
Aylesworth: In summary, we should talk about the industry and the outlook for natural gas. As a result of using new drilling techniques and new technologies we now have under our political control tremendous resources of natural gas. It’s a clean fuel, and with the abundant supplies it is now at a reasonable cost. So we don’t need to import it. As power plants age that burn coal, we can see growth and use of natural gas as their replacement. There’s talk of natural gas to replace diesel in terms of transportation including commercial and personal vehicles and finally there are export opportunities. So there are a lot of growth opportunities for the portfolio’s companies as we take advantage of this new phenomenon.
Forbes: Sounds like a good combination.
Aylesworth: With that, I will say thank you very much.
Forbes: I think that’s terrific, Skip. You make a very strong case.
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