The Electric Grid Index

Charles Morand

A little while ago, we received the following request from a reader:

While we don’t plan on launching a licensable index or a mutual fund because of all the regulatory thicket we’d have to cut through, this request nonetheless led to a few internal exchanges about the merits of this idea and what could go into such an index/fund.  

Tom had the following to say:

Neither the electric grid (let alone the transmission subsector) nor energy storage, taken alone, features a sufficiently large universe of stocks to allow for the construction of a solid index and, in turn, the creation of a dedicated ETF or mutual fund.

The small number of firms for which either sector is material means that effectively all of the available stocks would have to be included in the index to achieved a level of diversification worth paying for, if such a level was even achievable. A small number of stocks also means that an investor might be able to reproduce the portfolio directly on his/her own at a lower cost than the ETF management fee.

Efficiency is somewhat different, seeing as so many activities and products – including some that fall under the grid umbrella – can be counted as ‘efficiency’. Besides your garden variety electricity efficiency solutions such solid-state lighting, everything from insulation technology manufacturers to demand-side management service providers could be included. Of the three, efficiency stands the greatest chance of seeing its own ETF pop up in the near to medium term – in fact, I wouldn’t be surprised if someone was already working on this.  

Nevertheless, this request and the subsequent discussion piqued my interest, and got me wondering what an Electric Grid Index might look like – I decided I would give it a shot.

The electric grid has received a significant amount of focus in the bailout package and has recently been on the political radar to a greater extent than at any other time in the past few decades.

Last week, the results of a survey of wind power firms revealed that “transmission or interconnection issues [are viewed] as the single greatest barrier to wind development in the United States. ” Transmission is also a significant barrier to geothermal power development and, as utility-scale facilities gain in popularity, will definitely become so for solar PV as well.

In my view, the grid will be one of the strongest performing sub-sectors in alt energy over the next four years, because so much of America’s renewable power potential depends on a significant expansion of domestic transmission and distribution capacity. At the same time, the growing popularity of smart grid technologies, as evidenced by the Obama administration’s efforts to jump-start this sector, will most likely expand in the years ahead as utilties and large consumers become increasingly comfortable with the concept.

The Electric Grid Index

Last February, I wrote a post where I differentiated between what I called the Old World and the New World grids. In a nutshell, I ascribed the New World label to companies working on making the grid into an information-rich environment that can be managed dynamically by using two-way communication, aka the smart grid. Old World companies are firms working on more conventional areas such as cables, towers and maintenance.

I also added a new category: A Bit of Both. This idea came after a reader pointed out the importance of power electronics in enabling a smarter grid, and the need to not be so clear-cut when discussing the Old and the New Worlds. This category also contains firms that actually do do a bit of both.

In order to create a basic list of stocks for a smart grid index, I went back over past articles we wrote on the matter and pulled out a list of firms that had been identified as plays on the grid. I then read through their 2008 10-Ks, 20-Fs and/or annual reports and included only firms that derived 20% or greater of their revenue from the grid or power management activities.

I left out MW-scale storage although the case could certainly be made for adding it…or not. I also left out system operators such as ITC Holdings (ITC) and focused instead on product and service providers.

The following is the final list of grid companies I came up with.      
    

Coming up with a simple list is easy enough. However, in order for this list to be considered an index in the true sense of the term, individual stocks have to be weighed according to certain criteria – the weight different stocks and sectors receive is critical to performance for this type of index.

Depending on who creates and index and for what purpose, methodologies for ascribing weights to different stocks can vary. In this case, since this is a purely fictional exercise, I originally opted for a simple capitalization-weighted methodology.

The problem I ran into with using straight capitalization-based weights is the huge discrepancy between the size of the A Bit of Both stocks and the rest: together, they account for nearly 90% of the list’s capitalization. This means that even large movements in several other index components would have a marginal effect at best on index performance if those three did not move or moved in the opposite direction.

I thus decided to give each of the three categories (New World, Old World and A Bit of Both) and equal weight of 1/3, to measure each capitalization’s weight within its own category only, and to do a weighted-average of those weights using 1/3. For example, Siemens accounts for 54% of its category’s aggregate market cap, so its weight in the index is 0.54 * (1/3) = 17.85%.

The 1/3 weight is arbitrary. If I were to create an index like this for purposes of an ETF, my preference would be to rely heavily on business and fundamental information in deciding how to weigh individual stocks. However, given the time and cost involved in conducting solid fundamental analysis on 18 companies, this isn’t something I would do for a simplified demonstration such as this one.

The category weights could be changed to reflect sectoral expectations. For instance, a less risk-averse investor could weigh the New World category more heavily as it is likely to generate stronger capital gains, although those will almost certainly come at the expense of lower volatility.

The index is set at 100 for now. I will measure performance periodically to see how I fare.

While it may not be practical for many investors to reproduce this index because of the number of stocks, I hope it provides a good base to start from. Tom is often a proponent of the portfolio approach to investing (i.e. taking small positions in several stocks to spread risk), and such lists can often provide a good starting point for those interested in following this approach.          

DISCLOSURE: Author is long ABB