10 Questions With Utilitarian Bern Fleming

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Bern Fleming used to work in a nuclear sub. Now he runs a utilities fund, which hasn't felt much safer this year.

Utilities used to be thought of as a sleepy pocket of the market reserved for widows and orphans, but that's not the case today. Between the telecom sector's collapse, the California power crunch and the bankruptcy of energy trading giant Enron(ENE Quote), the sector is looking downright volcanic. The average utilities fund has lost a quarter of its value over the past year, and averages a 3% annual loss over the past three years.

To sort through this mess we sat down with Bern Fleming, who has run American Express'(AXP Quote) (INUTX Quote)AXP Utilities Income fund for seven years. Unlike some of his colleagues, the former engineer doesn't make outsize bets on companies or industries, and his diversified approach has worked out pretty well. The fund tops its average peer over the past one, three and five years.

But like most utilities funds, his is under water this year, and he's not afraid to point out the sector's "Enronitis." What's he buying, what's he avoiding, and what does he see down the road? Read on.

1. What would you say right now is the case for investing in utilities?

The case is a combination of a decent yield and earnings growth, with fairly low risk and, I believe, a total return package that should rival that of the S&P 500.

2. What's the ripple effect of Enron? Where does it leave the power trading business and how long does it cast a pall over the sector?

It certainly cast a pall over the group. For the last couple of weeks in utility land, every day has been a red page on the screen. I don't know how long this will go on, but the market has become more sensitive to any news that has any connotation of Enronitis. It doesn't matter if subsequently that information is discounted or proven to be untrue -- the damage is done first. So we've certainly got a lot more sensitivity in the marketplace.

Talking With: Bern Fleming

Fund: (INUTX Quote)AXP Utilities Income

Managed Since: Jan. 1, 1995

Assets: $2.3 billion

1-Year Return: -18.6%/Beats 67% of Peers

5-Year Return: 9.5%/Beats 69% of Peers

Sales Charge: 5.75%*

Expense Ratio: 1.03% vs. 1.43% category avg.

Top Holdings: Verizon BellSouth Dominion Resources

Sources: Morningstar. *Maximum sales charge on Class A shares. Returns through Dec. 10.

Yet not that long ago I thought most electrical utilities' earnings growth would be around zero or down 2% for the year. Today, I think most will see 5% or 6% earnings growth with a 4% yield to boot. I have a suspicion that 5% to 7% earnings growth will be very competitive with the S&P 500 on average.

3. Did you own shares of Enron, and how did everyone miss the boat?

We had a large amount of shares at the beginning of this year. A year ago it was a 4% or 5% position in the fund, but those shares were sold in the first half of this year. As Enron got weaker and weaker, I thought it was a steal and I built a 1% position in the fund. A few weeks later I realized that something's not right here.

How do you catch it? Enron was a tough read. They did some really great pioneering work in the trading area when they first came on the scene 10 or 15 years ago. I remember thinking, "This seems kind of hokey." But it didn't take long to realize that they were really on to something. The products they developed were wonderful and really needed in the marketplace.

The first thing you try to do [in looking at a company] is make a management judgment. And maybe that was the key because there were significant departures from Enron over the years. A real key [metric] is often what a company is doing with its working capital. But once something is shoved off balance sheet and there isn't good disclosure, you probably would not normally look further. I guess one way to catch it is to maintain a diversified portfolio. I can't think of a better advertisement for it than Enron.

Bern, Baby, Bern Fleming's fund has topped its average peer every year since 1995

Source: Morningstar. Returns through Dec. 10.

4. In light of what we've seen, where are you investing shareholders' money today? What companies are standing out to you as having attractive valuations, predictable earnings and an attractive yield?

You're asking a key question and it's one that I've been wrestling with every day for a good 30 days here at least. I'd point to some of the larger positions in the fund, like Dominion Resources(D Quote), Duke Energy(DUK Quote), Entergy(ETR Quote) and El Paso Energy(EPG Quote). These companies have a mix of assets. They do merchant trading and they have power plants that are deregulated. They also have operations that are either regulated or somewhat regulated. They've got quite a wide base of operations that may include everything from exploring for natural gas right on through sending it to a customer. A couple of months ago you would've called these the ugly integrated companies, but today they look pretty good.

5. What looks overpriced and what are you avoiding today?

I have a very difficult time judging what's overpriced right now because, as I look around, I've got a whole lot of price-to-earnings multiples based on next year's estimates in the 8, 9 and 10 range. That's half the S&P 500's valuation for next year, and utilities usually trade at about two-thirds the S&P's P/E multiple.

If you look at the independent power producers, they have P/E multiples below 10, and I don't think I've seen any reduction in their earnings rates. You think to yourself, "Gee, what's going on here?" but as you indicate and I agree, there is a pall. There is a big question mark about, are these companies being sufficiently forthright in terms of what they do? And all these conference calls, as they try to explain themselves, create a problem: They doth protest too much.

Widows Indeed Utilities funds aren't the sleepy haven they used to be

Source: Morningstar. Returns through Dec. 10.

6. Do you think the pressure on stocks like Calpine(CPN Quote) is legitimate after Enron?

I think they're a little bit different. In a small way, you could say they're the same. Can Calpine sell equity today? Certainly not. Can they access the debt markets? Well, I would think so. It'll be expensive, but they can probably do it. Calpine has choices. One of the reasons they have an appetite for capital is their [power plant] expansion program. They don't need the line of credit to support their trading operation. We saw Enron burn through, what, 3, 4, 5 billion dollars there in a couple of weeks? My goodness, Calpine's not in that position at all.

But you're leery of the independent power producers as a group?

Oh yes. If you're asking me if I wish I didn't own any of them, sure.

Which do you own?

At the moment I own three: Dynegy(DYN Quote), Mirant(MIR Quote) and Entergy.

7. What happens with Dynegy?

It's certainly being tarred with the Enron brush, but at the same time they've got some very interesting assets. I would think that the $1.5 billion they forwarded to Enron will eventually give them the natural gas pipeline they're after, which is quite a good asset. They also are partly owned by ChevronTexaco(CVX Quote), and there's a pretty strong relationship between those two firms. It's hard for me to say that this company is too similar to Enron. I don't really see anybody like that.

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8. Prior to the past two weeks, telecom has been a black hole. Are you seeing values there?

In telecom I've become more interested in the big uglies. I'll use that term to describe some of the electrics and some of the phones, you know, Verizon(VZ Quote), SBC Communications(SBC Quote) and BellSouth(BLS Quote).

You've got a pretty good cash flow and their capital expenditures seem to be coming down to a more reasonable level. That allows them to strengthen their balance sheets a bit. Yes, one could say that voice is on a decline curve, but wireless is holding up pretty well, and they have good exposure to wireless.

When you get into long distance, I'd have to say that's a minefield I don't fully understand. I do have some exposure and own some of the long-distance names, but that's a little difficult arena. I myself can't decide what I should own there. And when you get into the, I don't want to say dot-commers, but competitive carriers, I don't own any of those names at this moment.

I have to ask myself what kind of stock does a utility fund investor expect to see? They probably expect to see a Verizon, but they might not expect to see Global Crossing (GX Quote) or some of the other [upstart and volatile] names. And if they did, I'd probably get a phone call. I don't have a good picture of what to do with some of the other names, whether it's Allegiance Telecom(ALGX Quote) or Time Warner Telecom (TWTC Quote) or some of the others. I think they might have a decent business plan, but I'm not quite there yet as far as investing.

9. Utilities is traditionally considered a sleepy defensive sector, but some would argue that's not true anymore, given its performance in this downturn. Is that a fair statement?

Well, it's been pretty steady since this fund was started [in 1988] except for this year when one month phone stocks will work, the next month they don't, and then the independent power producers will work and then the next month they don't.

I do run a mixed fund. I own natural gas, electricity and telecommunications stocks. Generally, that has proven to be quite sound. This year I'd have to say it's almost like owning dynamite. We had that crazy stuff in California, and now we have this thing with Enron. You put those three things together, and it's pretty rough on utilities.

10. What are a few companies on your radar screen that you'd be confident holding for five years, given their management, the predictability of their earnings and the stock's current valuation?

This really addresses management, I believe. Even the best management will stumble once in a while but should be able to correct itself. I'd point to Duke Energy, which is a good company with good assets and good management. I'd mention Dominion Resources for similar reasons. A plain-vanilla electric utility I'd pick is Southern(SO Quote). It's not cheap, but they don't do anything stupid. Nothing wrong with that definition. I probably at this juncture have to leave the independent power producers alone, even though I think there are some real opportunities there, simply because people don't seem to be interested at this point.

In looking at the natural gas area, I'd say El Paso Energy has a good mix of assets. In telephone land I'd say Verizon, BellSouth and AT&T Wireless(AWE Quote).