ERH: Good Management, Good Yield

Aug.13.14 | About: Wells Fargo (ERH)

Summary

ERH is a closed end fund with a manageable yield.

The fund focuses on investing in stocks and bonds of utility companies and has returned over 100%.

The management team has done a pretty good job of making the right decisions for its shareholders.

Wells Fargo Advantage Utilities & High Income Fund (NYSEMKT:ERH) is a closed end fund that started in April 2004. Its objective is to seek a high level of income and capital growth by providing dividend income. The fund focuses on investing in stocks and bonds of utility companies. The other holdings come from telecom equities, energy equities, and government bonds.

On the Yahoo Finance graph below ERH hasn't done well. It has a -39.3% return in ten years. Its performance is better after the dividends. This return is 71.25%

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I think much of the price performance has to do with the financial crisis. ERH took a hit in 2009 just like everything else. Since its lowest point in 2009 ERH has been doing great. It has a total return after dividends of 106.85%. See the Yahoo Finance graph below.

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The management team has done a pretty good job of making the right decisions for its shareholders. Below are several things I think gives it an advantage over other closed end funds.

Distribution:

Its distribution policy seems to be in line with its mission statement. Over the past four years the dividend has been a steady $.075 a month. This is about a 7.33% yield. This seems to be manageable. Looking at its fact sheet here one will see that the average coupon on its bonds is 6.78%. I went to it's holding list here and calculated the yield on the 15 largest stocks. The average yield for these stocks is over 3%. The combined yield is 9.78%. This is above the 7.33% yield it pays out. This gives it some cushion in case another crisis happens. The extra yield could be returned as a special dividend or could be reinvested back into the fund. Another thing about its distribution is that it's coming from income. Closed end funds have the ability to have their distribution be a return of capital. This is taking the money that was used to buy the fund and giving it right back to the investor. This can shrink the capital base of the fund.

Bond risk:

25% of the portfolio is made up of bonds. 25% of this is in cash equivalents and government bonds. These are essentially risk free. The rest is invested in corporate junk bonds. I don't believe that these are risky either. It invests in over 200 corporate junk bonds which gives it a safety net if some default. The average maturity of all the bonds is three years. This decreases interest rate risk, default risk, and redemption risk.

Stock risk:

ERH holds 48 different common stocks. 62% of them are in the utility sector. This would cause sector risk. However, utility companies are usually the most stable during a downturn in the economy. It also invests in large value cap stocks. 62% of them are in this category. Large cap stocks have a steady dividend and a stable price. The stocks have a decent yield of over 3%.

Rights offering:

A rights offering is the ability of a fund to create more shares by offering current holders the option to buy more at a discounted price. This can destroy the market value of a fund. ERH has never done a rights offering. This is a sign that the management team is not taking on too much risk. It isn't trying to offer an unsustainable yield and can manage its investments without help. Some companies, like Cornerstone, do these all the time for its funds.

Leverage:

ERH uses leverage. If an investor can handle a little leverage this would be a good fund to invest in. From its fact sheet 14.5% of its funds come from borrowing. The averages rate on this borrowing is 1.03%. One way it could be using the borrowed money is to invest in bonds. The bonds' average coupon is 6.78%. ERH would be making 5.75% off the difference. If it is using it to buy stocks it's making about 2% more. In the past 5 years ERH has returned over 100%. There is no way to determine how much leverage has helped but in no way has it hurt.

I believe ERH is doing a lot of things right. So what puzzles me is that since November of 2011 it has traded at a discount to its NAV. The graph below came from Morningstar.com. The price as of August 8th 2014 is $12.32. The NAV is $13.39. This price is 8.8% lower.

There are a few reasons why this could happen. One reason could be market variables. The price of an investment has many different factors determining it. Some of these can't be quantified. NAV is calculated by a formula. Another reason could be that supply and demand are temporary unaligned. A different reason, which would be more severe to ERH, is that investors may not consider ERH's management team to be adequate. One theory could be that the yield is too low. Investors may think the yield should match the income the fund is receiving. Also, borrowing rate is really low. Investors may want there to be more borrowing to get higher returns. These are all theories. There is no mention of NAV in the fact sheet. This part is open to a lot of interpretation.

I believe in the fund and its managers. I bought some shares back in April of 2013 at $11.94. Today it trades at $12.47. The price has given me a 4.4% return. I have reinvested the dividends and that has brought my total return over 13% I am very happy with that kind of return in a little over a year.

Disclosure: The author is long ERH. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.