DPG: An Interesting Utilities CEF With A Large Distribution And Trading At A Sizable Discount

Summary

  • Utilities are a popular asset class among conservative investors due to their relatively low risk and high dividend yields.
  • The yields on these companies have been disappointing lately but DPG uses leverage to enhance it to something quite appealing (about 9%).
  • The fund is reasonably well-diversified, although for a global fund it does still have outsized exposure to the United States.
  • The fund has managed to grow its NAV per share despite making return of capital distributions, providing tax benefits to investors without depleting its assets.
  • Unlike many funds today, the market has not bid up this one and it still trades at a fairly attractive discount to NAV.
  • Looking for a portfolio of ideas like this one? Members of Energy Profits in Dividends get exclusive access to our model portfolio. Get started today »

Utilities have long been a popular asset class for conservative investors seeking income. However, the current low interest rate environment has resulted in the stock prices of even these low-growth companies being pushed up to the point where their yields leave a lot to be desired. This has undoubtedly led these investors to seek out other options for income. Fortunately, there are some opportunities available for these investors, especially if they are willing to look internationally. Many of these can be found in the closed-end fund space, where some of the highest yields in the market can be found. One such potential opportunity is the Duff & Phelps Global Utility Income Fund (NYSE:DPG), which both boasts a very high yield and exposure to a variety of different utilities with one easy trade.

About The Fund

According to the fund's web page, the Duff & Phelps Global Utility Income Fund has the objective of providing a high level of total return that comes primarily from a large degree of dividend income, with capital appreciation providing a smaller amount of total return. In order to achieve this objective, the fund invests its capital into the equities of domestic and foreign utilities. It does this in order to collect the dividends paid out by these companies as well as benefit from their historical growth. The fund emphasizes that it uses leverage to enhance its returns, which is a double-edged sword as we will discuss in a bit.

Different market participants have different definitions of what exactly is considered a utility. An obvious example is whether a telecommunications company like AT&T (T) or Verizon (VZ) is a utility. From the perspective of this fund's management, a utility is a company that operates in the electric, gas, water, telecommunications, or midstream energy sectors. The fund divides its assets among the various sectors fairly well and does not appear to be overexposed to any single industry:

Source: Duff & Phelps

With that said though, the fund does definitely have more exposure to the "traditional" utility sectors like electric, gas, and water and midstream companies than it does to the other industries that it classifies as utilities. All of the sectors in which the fund invests in are well below its 60% maximum in a given category that is laid out in the prospectus so we can see that the fund is currently more diversified than it potentially could have been.

We can also see the fund's diversity across various utility sectors by looking at the top ten holdings of the fund. Here they are:

Source: Duff & Phelps

One company that certainly may raise some eyebrows here is Crown Castle International (CCI). This company is usually classified as a real estate investment trust and is, in fact, one of the largest positions in the domestic real estate indices. However, as it is a cell tower REIT, it is also a major player in the supporting infrastructure for the nation's telecommunications network, which increasingly is made up of cellular devices instead of fixed-line ones. The remainder of the fund's largest holdings is much closer to what most people would consider utilities. We can also see here that there are both domestic and foreign companies contained in the largest positions, which both supports the fund's global theme and adds a certain amount of international diversification. With that said though, the fund is still quite heavily invested in the United States:

Source: Duff & Phelps

As we can see, 57.3% of the fund's assets are invested in United States-based companies but the United States does not make up anything close to 57% of the global economy. This kind of outsized exposure to that country is something that is fairly common among global funds and may simply be due to most of the fund's investors as well as its managers being more familiar with this country than they are with others. Nonetheless, it is important to consider this outsized exposure when making an investment decision. This is particularly true if you are hoping to use a fund like this as a way to diversify your domestic-heavy portfolio as you may not achieve the diversity that you desire.

The fact that the fund does have just over 40% of its assets invested internationally does provide a certain amount of protection against regime risk. Regime risk is the risk that a government or other ruling authority will take some action that has an adverse impact on the companies that are based in its jurisdiction. We can protect ourselves against this by spreading out our investments across a variety of different nations so as to limit the impact that the decisions of any single government will have on the portfolio as a whole. As we can see, the fund does do this to a certain extent.

One other nice thing that we see here is that DPG is not overexposed to any individual asset. As my regular readers on the topic of closed-end funds are likely aware, I dislike seeing any individual position account for more than 5% of the fund's total assets. This is because this is approximately the level at which a position begins to expose the entire portfolio to idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk which any financial asset possesses that is independent of the market itself. This is the risk that we aim to eliminate through diversification. Thus, the concern is that some event will occur that causes the price of a given asset to decline when the rest of the market does not and if it has too high of a weighting then it will drag the rest of the fund down with it. As we can see though, there are no assets here that individually account for an outsized portion of the portfolio so we do not have to worry about this risk with this fund.

Why Invest In Utilities

Utilities are a very popular asset class for retirees and other conservative investors that are concerned about the safety of their principal but still have a desire to earn a better return than Treasury bonds and other safe assets can provide. This is due to the fact that utilities typically have very safe cash flows and business models. Think about it - most people will prioritize paying the electric, gas, or telephone bill in times of financial hardship over making discretionary purchases. In addition to this, utilities are frequently localized monopolies that are regulated in order to ensure that they make a profit and are financially stable. This only adds to the appeal of these assets in the mind of risk-averse investors.

Perhaps the biggest downside to utilities is that they tend to have very low growth rates. This is because they are localized monopolies and typically have every resident and business in their coverage area as customers. This situation results in these companies paying out a sizable proportion of their free cash flow to investors in the form of dividends. Thus, these companies usually have higher dividend yields than firms in other industries. Of course, in today's low interest rate world, the yields on utility stocks are quite a bit lower than they used to be.

Distributions

As already mentioned, the low interest rate environment that has dominated the developed world over the past decade has pushed up the price of utility stocks and driven down their yields compared to what was previously the case. As of the time of writing, the U.S. Utilities Index (IDU) yields 2.48% and the Global Utilities Index (JXI) yields 3.07%. Neither of these yields is particularly impressive. Fortunately, DPG boasts a substantially higher yield than this. The fund pays out a distribution of $0.35 per share quarterly ($1.40 annually), which gives it a 9.00% yield at the current price.

One thing that may be concerning is that a significant proportion of these distributions is classified as return of capital. We can see this here:

Source: Fidelity Investments

The reason why this may be concerning is that a return of capital distribution may be a sign that a fund is not bringing in enough money off of its investments to cover the distributions that it is paying out to its investors. A scenario such as this is ultimately unsustainable because the fund would eventually run out of money to distribute. There are other things that can result in a distribution being classified as a return of capital though such as the distribution of unrealized capital gains or the distribution of money received from energy partnerships (which this fund does invest in). The important thing is whether or not the return of capital distributions are destructive to the fund's net asset value.

Here we can see DPG's net asset value history over the past year:

Source: Morningstar

As we can very clearly see, the fund's net asset value per share has increased over the past year. This happened in spite of the return of capital distributions that it was paying out as well as in spite of the market calamities in the fourth quarter of 2018 and May of 2019. Thus, we can conclude that the distributions are not at all destructive to the fund's asset base and its shareholders should simply enjoy the tax-advantaged distributions here.

Leverage

One thing that potential investors will almost invariably notice is that the yield on DPG is considerably higher than either the domestic or global utilities indices and also higher than the yield of almost any company held by the fund. One way in which the fund accomplishes this is through the use of leverage. Basically, the fund is borrowing money in order to invest in utilities stocks beyond what it could do if it could only use its own capital. If the dividend yield on the securities that the fund purchases with this borrowed money is higher than the interest rate that it must pay, then this works to increase the effective yield on the fund's portfolio. As DPG is able to borrow money at institutional rates, this is generally the case.

Leverage is a two-edged sword, however, and amplifies both gains and losses. Thus, when things go south a leveraged investor stands to lose more than they otherwise would. This concept is explained in more depth here. As a result of this, we will want to ensure that the fund does not take on too much debt and increase our risk to unacceptable levels. As of the time of writing, DPG had a total leverage ratio of 28.62%. This is not really out of line with what many other closed-end funds use and is a reasonable trade-off between the risks and potential benefits. It is not until this ratio starts getting beyond 30% that I usually start to get concerned.

Valuation

As is always the case, it is critical to ensure that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate sub-optimal returns from it. In the case of closed-end funds like DPG, the usual way to value them is by looking at the fund's net asset value. Net asset value is the total current market value of all of the fund's assets minus any outstanding debt. It is therefore the amount that the fund's investors would receive if it were completely shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can acquire them at a price that is less than net asset value. This is because such a scenario essentially means that we are acquiring the shares for less than they are actually worth. Fortunately, that is the case right now. As of September 24, 2019 (the most recent date for which data was available as of the time of writing), DPG had a net asset value of $17.05 per share. However, the shares of the fund only trade for $15.55, which works out to a 8.80% discount to net asset value. This is a fairly attractive discount right now considering that the market has generally been bidding up shares of closed-end funds lately.

Conclusion

In conclusion, utilities have long been very popular investments among those that are conservative and risk-averse such as retirees. This makes sense given their relative stability and captive markets. The Duff & Phelps Global Utility Income Fund offers an interesting way to play the sector and generate a higher-than-average distribution yield at the same time. The fund has certainly held up well through the market volatility that we have seen over the past year as well, which is also likely to be appealing to those investors. With that said though, the fund does use leverage and in so doing adds a degree of risk. The price certainly looks right though, so overall it might be worth considering.

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