In his annual letter to investors, released on 24 February 2024, Warren Buffett drew the public's attention to the increasing wildfire risk that electric utility investors in parts of the US are exposed to.

He confirmed this risk had negative ramifications on essential investment required to support utilities and communities alike. This messaging was further reinforced by the experience of Xcel Energy, who in early March confirmed that its assets in Texas were likely responsible for the ignition of the Smokehouse Creek wildfire.

Strong words from Buffet on an increasingly concerning utility risk

Buffett drew broader investor attention to an issue which is already well understood by US utility investors, attributing the poor performance of Berkshire Hathaway Energy (BHE) to increased wildfire risk - to "the regulatory climate in a few [US] states has raised the spectre of zero profitability or even bankruptcy (an actual outcome at California's largest utility and a current threat in Hawaii)".

This was in reference to BHE's utility company, PacifiCorp (referenced in the previous article listed above), which BHE believes is facing at least $8 billion in legal liability claims associated with fires it allegedly ignited in October 2020^[1]. The scale of such potential liabilities obviously raises the question of the financial viability of PacifiCorp.

To this Buffett stated, "At Berkshire, we have made a best estimate for the amount of losses that have occurred. These costs arose from forest fires, whose frequency and intensity have increased - and will likely continue to increase - if convective storms become more frequent".

Importantly, with regard to BHE's appetite in bailing out the company from financial distress Buffett stated, "Berkshire can sustain financial surprises but we will not knowingly throw good money after bad"^[2].

This should be a major concern for legislators and regulators in exposed states, as an electric utility in financial distress (potentially bankruptcy proceedings) will struggle to attract investment capital and service its customers. This is particularly important in the current environment, with massive capital investment required to support the energy transition and power demands of AI and data centres. Indeed, Buffet recognises the investment proposition on which utilities were historically based could be in question, "Now, the fixed-but-satisfactory return pact has been broken in a few states, and investors are becoming apprehensive that such ruptures may spread".

Xcel Energy the latest utility at risk

Shortly after the release of Buffett's investor letter, Xcel Energy confirmed that its assets are likely to have ignited the Smokehouse Creek wildfire in Texas. A lawsuit against the company has claimed that one of the company's utility poles near Stinnett, Texas, had been blown over by strong winds sparking the initial blaze.

The fire based in the largely rural Texas panhandle and parts of Oklahoma burnt around 1.2 million acres, destroyed 400-500 structures, and is associated with two casualties. Despite it being too early to understand the potential legal liabilities facing the company, Xcel Energy's share price fell 17% (representing a c.US$6 billion devaluation in market capitalisation) in the week after media reports implicated the company in the fire. This again reinforced the risk facing electric utility investors from the unintended ignition of wildfires.

The states, and therefore companies, physically exposed

One major problem in identifying wildfire risk is that the geographies exposed to wildfires are increasing over time as a result of global warming - which we touch on in our article,  Extreme weather risks and their impact on investors. Despite the increasing occurrence, the states that are currently most exposed to wildfires are depicted by UBS below, utilising data provided by FEMA on the National Risk Index. The map shows that the highest risk areas are in the western, central and southern parts of the US.

^{Source: California Board of Forestry and Fire Protection (CAL Fire)}

The map helps identify states that are most exposed to wildfires, and the utilities which have significant operations in those states (listed in the table below). This provides a first pass as to utilities in 4D's investment universe which have/could have risk from wildfires.

This a high-level geographic assessment only and captures many of the US utility operators. A deeper dive would see some with little real wildfire exposure at present as they operate in more urbanised areas with little vegetation to support the damaging fires - for example CenterPoint Energy Houston Electric (in the Texas section of the table above) have confirmed that their operations in downtown Houston is highly unlikely to be impacted.

Other considerations to wildfire liability exposure

Other major considerations as to electric utilities' exposure to wildfire liabilities include:

 1) how prepared electric utility companies are to mitigate physical wildfire risks;

2) what litigious environments exist in various states; and

3) are companies able to manage wildfire liabilities of various scale if incurred?

These are the areas that 4D undertakes significant due diligence in when considering a company for investment.

When researching a potential investment in a US electric utility that is in (or could develop into) a high wildfire risk geography, we spend significant time understanding the company's wildfire mitigation preparedness.

This incorporates getting a thorough understanding of wildfire mitigation plans in its totality, which incorporates vegetation management processes, situational awareness (video monitoring of the network, lineman visual inspections, and drone surveillance), investment in hardening the network from fire ignition, and established public safety power shutdown (PSPS) procedures as a last resort. Significant investment in the insulation of overhead wires, replacement of weak/old power poles and undergrounding of wires in particularly high-risk regions all 'harden' the grid from wildfires.

The particular litigious framework established in individual states identified in the table above vary considerably. Some key factors, which will influence the level of legal liability risk, include:

• Absolute cap on liabilities - some states have established legal liability caps on the absolute amount that an individual/company can be litigated for.
• Judge vs jury presided courts - jury courts are more likely to be influenced by their emotions (with wildfire damage being very emotional for communities) rather than by the strict interpretation of the law.
• Whether punitive damages can be applied in addition to actual (property) damages -punitive damages are often multiples larger than actual damages, which are usually massive for wildfires in their own right. The application of punitive damages is usually dependent upon the establishment of gross negligence on behalf of the company, which should have a high threshold of evidence, but this has been depleted in some examples. A jury court in Oregon ruled that BHE's PacifiCorp was grossly negligent in its operation of the network during the October 2020 fires in the state, based largely on the company not shutting power off in the lead up to the fires. This would have had far reaching operational ramifications that made the decision far from straight forward. The court's decision is being appealed. The level of wildfire preparedness (or robustness of wildfire mitigation plans) that a company can demonstrate will reduce the risk of being found (grossly) negligent by a court.
• Specific state-based legal concepts - some specific legal standards can be applied in individual states such as inverse condemnation in California (see The real risk of wildfires to US infrastructure investors for more information on this). 

The question of a company's ability to manage wildfire liabilities will be dependent upon its balance sheet capacity and liquidity, which are obviously influenced by its size. Smaller electric utilities, including smaller municipal owned utilities, will be less able to manage large legal liabilities and are more likely to be forced into financial distress and/or bankruptcy. Could this be a driver of M&A consolidation in some states?

A financially distressed company is unlikely to have the capacity and/or willingness to continue to invest much-needed capital in the networks (replacement, growth and hardening) which could hinder economic and social development in the exposed region.

We expect there will be growing questions around insurance for these events - what can be insured, what premiums will do as this risk intensifies, and when does insurance pay out? It could get harder for utilities to protect themselves from this risk.

4D's approach

Wildfire risk is becoming a bigger concern for market investors and is probably something that is still being understood. At 4D, we don't recommend avoiding these companies from investment altogether.

 We do, however, recommend thorough due diligence of the risk to a company before taking a position. As always, we balance quality, risk and return in making investment decisions. In some cases, that risk will be too great - as Buffett outlines, there is the potential for the adoption of risk that outweighs the potential regulatory return of a utility, which can end up in the loss of all equity value (as experienced by PG&E Corp). However, in others we see the moderated risk more than compensated by valuations, with network hardening against fires also a strong driver of earnings growth.

^{The content contained in this article represents the opinions of the authors. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.}

^{[1] Warren Buffett's western utility facing untold billions in wildfire damages after the latest bombshell jury verdict came down - The Associated Press; 7/3/2024}

^{[2] Charlie Munger - The Architect of Berkshire Hathway; Warren Buffett; 24/2/2024}

2023 global equity returns were dominated by an alphabet soup of megatrends. From (Chat)GPT shining the spotlight on the lifechanging potential of Generative Artificial Intelligence (GEN AI), to a broader adoption of Glucagon-Like Peptide -1 (GLP-1) diabetes drugs for weight loss and other obesity-related diseases.  These megatrends resulted in extraordinary share price movements across multiple sectors as investors crowded into the themes and quickly decided who the winners and losers may be.

As we head into the third month of 2024, we continue to see these megatrends dominate equity market returns. In contrast to 2023, there is a clear bifurcation between megatrend beneficiaries that can deliver revenue and earnings growth and those that can't.  This is not only evident within the Magnificent 7 ("Mag 7"), but also across other so-called GEN AI and GLP-1 winners and losers.

Alphinity continues to have selective exposure across both megatrends.  Within GEN AI, we have exposure to early AI winners, such as Nvidia and Microsoft. In addition, we continue to invest in opportunities across the broader AI ecosystem.  SK Hynix, ASML, Cadence and Accenture are examples of technology enablers and facilitators where AI is augmenting company performance. Importantly, we continue to look further afield across sectors to companies not only enabling AI but those that will also reap its benefits.

We also have a nuanced exposure to the GLP-1 megatrend where the initial market clamour to define "winners" and "losers" delivered some interesting opportunities. While market leader and key GLP-1 winner, Novo Nordisk, has seen strong share price gains, assisted robotic surgery company Intuitive Surgical was initially dropped into the loser bucket on account of minor exposure to gastric banding. The market has since recalibrated ISRG expectations, and the shares have more than recovered the initial knee jerk reaction.

A further broadening out of these megatrends should continue to create exciting new "show me" opportunities in 2024 and beyond.

GEN AI - Show me the earnings

GEN AI truly entered our lives in 2023.  OpenAI's humanlike generative AI Chatbot, ChatGPT kicked off a wave of excitement across consumers and companies.  What ensued was a whirlwind of AI investments and developments across multiple industries as companies explored different ways of delivering AI building blocks or integrating these technologies into their businesses.

During 2023, many companies in the AI ecosystem got swept up in the euphoria.  From the enablers and infrastructure providers on the front end (such as semiconductor makers and data centres) to those that design software and provide related services (including end-user applications and cloud computing), amongst others.  None more so than the Mag 7.

While 2023 saw the rising AI tide lift most Mag 7 boats, year-to-date there has been a large divergence in performance amongst the group, defined by those that can deliver earnings growth to justify high multiples and those who can't.  AI posterchild, Nvidia, has added another c60% YTD, to be up more than 440% since the start of 2023.  Importantly, during this time the Nvidia forward PE multiple has come down, from 44x to 32x. The stock has got cheaper as earnings have outstripped the remarkable share price growth. Other major enablers such as Amazon and Microsoft have continued to rally supported by strong results from increased AI demand also.

Meanwhile Tesla and Apple have been dethroned by GLP-1 winner Eli Lilly and AI winner ASML, who now occupy their top 7 spots in YTD contributors.  Both Tesla and Apple are facing a range of challenges, but also recently disappointed investors with the lack of progress with their AI related plans.

Bifurcation within the Mag 7 driven by strong earnings power or the lack thereof:  Nvidia derated despite 441% return over the 14 months

Source:  Bloomberg, 29 February 2024

While industry data suggest a rapid adoption of AI across industries, the enablers continue to lead the charge year-to-date.  Recent 4Q23 result releases and capex intentions underscore the longevity of investment intentions across enablers and adopters.  AI mentions were at all-time highs as AI diffusion becomes more commonplace and remains a top CIO priority.

While AI is emerging as one of the largest innovation cycles in decades, we are only in the early innings of its diffusion.  It will take time for AI to impact revenues and margins more meaningfully and more broadly.

Microsoft company quote 4Q23 results:  "We are also the leader in low-code/no-code development, helping everyone create apps, automate workflows, analyze data and now build custom copilots. More than 230,000 organizations have already used AI capabilities in Power Platform, up over 80% quarter over quarter."

Conclusion

In times when the stock market is infused with captivating megatrends, such as GEN AI and GLP-1, there is a tendency for investor expectations to overshoot. Resulting in share prices of perceived beneficiaries running on speculation and the fear-of-missing-out rather than fundamentals.  The intense market concentration and diverging price movements of the last 14 months is a good case in point.

Looking ahead, we expect to see a continuous evolvement and adoption of both GEN AI and GLP-1.  Assessing long term winners and losers along the way will be crucial and fluid.  At Alphinity, we will continue to deploy our agile, tested investment process to find "show me" megatrend earnings leaders in 2024 and beyond.

Equity markets were stronger in March. In the US, the S&P 500 rose +3.1%, the Nasdaq was up +1.8%, whilst in the UK, the FTSE 100 rose +4.2%. In Australia, the All Ordinaries Accumulation Index rose +3.1%. Gold and real estate were the top performing sectors, whilst communications was the worst performer. In terms of sector performance, there was no clear reason for the ~9% rise in the gold price in the month, whilst real estate stocks were boosted by falling bond rates.

Broadly speaking, inflation continues to gradually track down towards the top end of central bank inflation targets, providing confidence we have seen the end of interest rate hikes. This has been the main driver of strength in equity markets in the last five months in our view. In bond markets, the US 10-year bond rate fell -7 basis points (bp) to close at4.20%, whilst its Australian counterpart fell +17 bp to finish at 3.97%. The Australian dollar was again flat for the month, ending at US$0.65.

Conventional portfolio construction theory positions equities as the primary driver of returns, while fixed income typically takes a back seat as a low-return and low-risk asset class. However, this perspective often overlooks a crucial aspect of fixed income: its role in dampening portfolio volatility.

Protecting portfolios through the storm

Contrary to the notion that fixed income should exhibit a negative correlation to equities, suggesting that when one goes up, the other goes down, in our view, it's more accurate to view fixed income as a stabilising force within a portfolio. Instead of focusing solely on returns, investors should also consider the invaluable function of fixed income can have in reducing overall portfolio volatility and improving risk-adjusted returns.

Historically, equities have exhibited higher volatility, compared to bonds, reflecting the relatively stable income streams of bonds and their fixed coupon payments. While bonds can still experience price fluctuations, especially in response to changes in interest rates or credit risk, these movements are generally less pronounced compared to equities.

Even small bond allocations in a portfolio can help dampen portfolio volatility for a small reduction in overall return and improving risk adjusted returns (Sharpe ratio).

Chart 1: Historical risk adjusted return comparison of bonds and equities

Source: Bloomberg, Yarra Capital Management

If equities and bonds were negatively correlated, fixed income would never deliver positive returns over the long-term. As shown below (refer Chart 2), the correlation is slightly positive.

Chart 2: Australian equity and bond correlation (post 1989)

Source: Bloomberg, Yarra Capital Management

While it's true that fixed income returns may lag during bull markets, the trade-off can be crucial: in times of market turbulence, fixed income can serve as a critical buffer against sharp declines in equity values, helping to preserve capital and reduce overall portfolio risk (refer Chart 3).

Chart 3: cumulative bond and equity returns

Source: Bloomberg, Yarra Capital Management

For much of the past 30 years, equity and bond returns have tracked each other. However, over the past decade, equity returns have significantly outstripped bonds by a considerable margin. This period coincides with governments and central banks pumping considerable liquidity into economies.

While the relationship between equities and bonds may still hold, (refer Chart 1), a combination of both asset classes can yield high returns while offering some important protection against equity corrections.

In essence, the role of fixed income extends beyond generating returns; it can provide a vital layer of defence against market volatility. By diversifying portfolios with fixed income, investors may achieve a more balanced risk-return profile, thereby enhancing long-term wealth preservation and stability.

Investing is not just about chasing high returns--it's about safeguarding against the inevitable storms that come our way. Rather than viewing fixed income solely through the lens of negative correlation, in our view, investors would be wise to remember its true value as a potential dampener of volatility and a of prudent portfolio construction. And in that regard, in our view, fixed income remains an indispensable ally.