Produced with Julian Lin for High Dividend Opportunities.
The recent market volatility has been difficult to stomach for many investors. Just last week, we explained in an article here on Seeking Alpha what is behind this market turbulence, and why we are not worried about the state of equities.
Still there are some investors - including "income investors" - who do not like to see fluctuations in their portfolios. Recently, we have recommended to our conservative investors a defensive closed-end fund that carries a lower price volatility: Reaves Utility Income Fund (NYSE:UTG).
UTG is a closed-end fund which pays consistent monthly dividends and focuses on the utility sector. Utilities are one of the best sectors to be invested into during volatile or uncertain times. This is a defensive sector by nature as these companies tend to generate a stable income in both good an bad times. At the end of the day, everyone needs electricity and water to survive. UTG also has a beta volatility ratio of only 0.48 which means it's 52% less volatile than the general market.
What's more? This sector has underperformed the broader market due to fears of rising interest rates, despite the fact that most utility companies can grow their income over time, creating a buying opportunity.
This means that the 6.8% yield of UTG is a strong buy as investors are handsomely rewarded to wait for this defensive utility stock CEF to get the love they deserve.
It Has Been A Difficult Year for Utilities
Since the beginning of the year, utilities across the board seem to be facing a perfect storm. Master limited partnerships (MLPs) have experienced volatility upon an unfavorable Federal Energy Regulatory Commission (FERC) which disallowed the recovery of an income tax allowance in setting tariff rates for regulated cost‐of‐service pipelines.
Utility companies located in California faced strong headwinds due to wildfires, as the state government imposed liability of property damages to utility companies if their equipment is found responsible, regardless of whether or not it was negligent.
As the year went on, things have started looking brighter for utilities, especially for midstream companies.
Energy midstream companies followed the FERC report with analysis which more or less indicated actual impact to their bottom lines would be much less than feared. Furthermore, the price of crude oil (WTI) has seen a steady rally:
This has led to midstream companies performing quite strongly since the selloff:
Still, with midstream companies only making a small portion of all utility stocks, the persistent underperformance suggests that maybe something else is at play here - we discuss this next.
Utilities Are Not Bonds
Still, if we have a closer look at utility stocks, they have outperformed the general markets by a good percentage:
Despite the huge selloff, utility companies were able to maintain a much lower price volatility.
The Utilities Index sells for 16 times earnings, a notable discount to the 21.5 times earnings of the S&P 500. This suggests a possible relative undervaluation considering that utilities usually sell at a premium to the broader market:
(Edward Jones Utilities Sector Outlook)
We believe that it's no coincidence that this period overlaps with a striking rise in interest rates, especially the 30-year U.S. Treasury bond:
We can see that this correlation has been frequent historically, that is when bond yields go up, utility stocks go down:
(Edward Jones Utilities Sector Outlook)
In theory, the correlation makes some sense. Like bonds, utilities are very stable due to having very recurrent sources of revenue. On the flip side, utility stocks tend to be owned by dividend investors due to their higher dividend yields, leading them to be valued based on yield. This means that as bond yields move up, utilities may be sold off as their dividends become less attractive.
Despite the historical correlation, we strongly believe that this is painting with too broad of a brush. Along with the positive attributes of very stable and recurring revenues due to regulatory-supported barriers to entry, utility stocks offer something that bonds typically don’t: Growth. Whereas the Treasury bond may offer a very sturdy 3.2% yield, the sturdiness is also its disadvantage as it means that the best an income investor can ever expect is 3.2% in income (assuming no capital appreciation). Utility stocks however are able to consistently increase cash flows through rate increases as well as growth projects, leading to strong dividend growth potential between 5%-10%, as we will see below when we look at the top holdings. The average dividend yield of utility stocks is about 3.4%, suggesting that in addition to a higher current yield, utilities also are offering dividend growth which would push their total return potential to 8%-13% annualized.
That said, fears of interest rates rising are overblown. We recently analyzed this in detail. In summary, this is due to the following reasons:
Global economic growth remains fragile, largely due to an aging population and lower birth rate.
US interest rates, while low historically, are still comparably higher than many other countries especially those in Europe. The 10-year spread with German bonds was recently around 2.5%, suggesting that demand for U.S. yields may keep rates down.
Higher interest rates would increase the value of the dollar, which may disrupt emerging market development and impact U.S. economic growth.
Outstanding political tensions, including the ongoing trade war, increase economic instability and severely restricts the Federal Reserve’s freedom to raise rates.
- Most importantly, U.S. GDP growth is estimated to be at 3.1% in 2018, 2.5% in 2019, and 2.0% in 2020. That's healthy growth, not too fast to trigger an overheating and not too slow either. It's the perfect environment for equities and utility stocks. GDP growth and inflation has skyrocketed this year, but it will be much more moderate in the next few years. So new investors in this sector now are in a strong position.
The underperformance of utilities has created an attractive entry point - now we introduce how to invest in the sector.
Getting To Know The Fund
As stated in the introduction, UTG is a CEF investing in utility stocks. UTG aims to invest 80% in assets into dividend-paying common and preferred stocks and debt instruments of companies within the utility industry.
The fund is managed by W.H. Reaves & Company, Inc. (dba Reaves Asset Management), an investment advisor with 40 years of utility investment management experience.
Their industry breakdown is seen most recently:
UTG also occasionally supplements their utility stock assets with corporate bonds and U.S. Treasuries. As of April 2018 UTG held tiny positions in a high yield corporate bond from Frontier Communications (FTR) as well as very near-term Treasury bills:
The fund has a focus on tax-advantaged dividends. Since the Jobs and Growth Tax Relief Reconciliation Act in 2003, qualified dividends will be taxed at long-term capital gain rates which are capped at 15%. This compares favorably with the 35% federal tax rates which can be seen at non-qualified dividend sources. While the fund does invest in real estate investment trusts (REITs) and MLPs, which do not have qualified dividends, UTG has made a point of focusing on qualified dividends so that they can maximize qualified dividend income.
The leverage ratio as a percentage of assets was 29%. UTG has indicated that they intend to use leverage in order to enhance the distribution yield.
UTG charges management fees of 1.08% of assets which is very competitive in the high-yield CEF space. With interest expenses the fee amounts to 1.65%, which is still very reasonable considering the low management fee compared to the value-added that this very-experienced management brings.
Performance
UTG has been a strong performer even compared to its utilities index. We can see below that it has strongly outperformed the index long term:
Their strong history of active management as well as the strong total return potential of utilities due to their undervaluation are a strong combination for their future outlook.
Top Holdings
The top 10 holdings of UTG are seen below:
Looking over the holdings, we see many names that we like.
DTE Energy (DTE), the fund’s largest holding, is a diversified utility company based in Michigan with revenues from electric, gas, gas storage and pipelines, and power and industrial projects segments. DTE yields 3.1%, which at first looks small but DTE boasts a strong history of earnings growth and is projecting 5%-7% growth through 2022. This should help it continue grow its distribution at healthy rates going forward.
NextEra Energy (NEE) is the largest regulated utility company in America and also has exposure to green energy as it intends to invest significantly in renewable energy projects. NEE yields 2.58% but like DTE, has a strong growth profile. Its portfolio is very strong with an average 17-year remaining contract life and Baa1 counterparty credit rating. Distributions have grown on average 8.9% since 2005 and have no indication of slowing down.
Verizon Communications (VZ) is a telecommunications company known for having wide-spanning coverage in the U.S., as they boast having 98% coverage of the country’s population. A potential catalyst for VZ would be the adoption of 5G, which they have started adopting in parts of Houston, Indianapolis, Los Angeles, and Sacramento. Meanwhile VZ pays a nice 4.4% dividend yield.
Sempra Energy (SRE) gives investors access to the California markets through its utility subsidiary SoCal Gas, as well as Texas and Mexico. It's targeting 13% annualized adjusted EPS growth through 2020 which will come with 7%-9% distribution per share growth. SRE yields 3%.
Dominion Energy (D) is a midstream play which recently offered to buy out its MLP Dominion Midstream (DM), joining the latest consolidation trend. If the deal is approved, it may help D acquire lower costs of capital to fund the growth project pipeline. D pays a 4.6% dividend yield which has been growing for the past nine years.
Distribution History
UTG has been dividend growth CEF and this is very rarely found in the CEF space. It currently pays a $0.17 monthly distribution. The distribution has grown steadily the past few years:
(Chart by Authors)
As we can see below, UTG has paid distributions primarily from a combination of both capital gains and dividend income:
(Chart by Authors, data from CEFConnect)
The “orange” above refers to return of capital (‘ROC’). While ROC is usually destructive for fixed income CEFs, it's however not necessarily destructive for equity CEFs as long as the fund makes it up in capital gains. Very important to note: ROC for equity CEFs results in tax advantaged dividend income. One of the main reasons why equity CEFs distribute ROC is that even if they have a strong income from capital gains, but they may decide not to sell (or "book their profits on these capital gains"), so it may look that they are not covering their dividends - while they are strongly outperforming and covering the dividends which is the case of UTG, if we look at historical performance.
Valuation
UTG currently trades around $30.50 for a discount to NAV of 5.6%. This represents a six-month Z-score of 0.80, indicating that UTG trades approximately 0.20 standard deviations lower than the average NAV discount over the past six months. Its historical NAV discount and premium valuations are seen below:
Considering their consistent history of being a dividend growth CEF as well as even occasionally paying special dividends, we would not be surprised if shares even traded well-above NAV. This represents potential total returns of 6% at least in addition to the safe and growing dividend yield.
Risks
UTG is concentrated into equity stocks and thus may underperform if the broad market experiences a correction. Note that we are very bullish on the overall market and should note that utilities are less volatile and more defensive stocks than other equity sectors.
Most equities carry interest rate risk including utility stocks. As rates increase, interest expenses can go up. This can impact profitability especially for those companies that cannot grow their income significantly. We recently posted our views that we are at the end of the cycle for interest rate hikes in an article here on Seeking Alpha. This is for many reasons which include the fact that the economy is not going to keep accelerating. This year in 2018, inflation and economic growth are strong due to recent tax reform. GDP growth should slow down from 3.1% in 2018 to 2.5% in 2019 and only to 2% in 2020. Inflation is not going to be a big issue by the end of the year 2019. Also based on the most recent economic data, inflation seems to be under control.
Lower Price Volatility
According to Yahoo Finance, UTG has a three-year beta volatility ratio of 0.48, which means it's 52% less volatile than the general markets. That's impressive!
Bottom Line
In closing, utility stocks are set to outperform moving forward due to the discount to their historical relative valuation compared to the broader market. Furthermore, we believe that interest rates are unlikely to continue rising and even then, utility stocks are not bonds and thus should not move like bonds. UTG is great a way to get exposure to this defensive sector with monthly dividends at a 6.8% yield. For income investors, UTG is a solid buy to generate dividend growth at a lower price volatility.
A note about diversification: To achieve an overall yield of 9%-10% and optimal level of diversification, we recommend a maximum allocation of 2%-3% of the portfolio to individual high-yield stocks and a maximum of 5% allocation to high-yield exchange traded products (such as ETFs, ETNs and CEFs), like UTG. For investors who depend on the income, diversification usually results in more stable dividends, mitigates downside risk, and reduces the overall volatility of your portfolio.
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All tables and images from Reaves Utility Income Fund’s website, unless otherwise stated.
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