A while back, I wrote about the First Trust Energy Income & Growth Fund (NYSE:FEN), a small, relatively under-covered midstream energy fund. I said FEN was the best fund in its industry, as its strong distribution yield, decades-long history of overperformance, large discount to NAV, and outstanding investment strategy and holdings combined to create a low-risk, high-reward investment opportunity, and one with the potential for outsized total shareholder returns.
It's been a year since I wrote that article, and since then FEN has achieved 16% in total shareholder returns, the strongest results out of all energy, midstream and MLP funds, and significantly greater than the -14% posted by the Alerian MLP Index (AMLP). Outstanding results, but more or less what I expected.
In this article, I'll be revisiting FEN and taking a close look at the fund and at the broader midstream energy industry. FEN's overall investment thesis remains broadly the same, so I expect similar results from the fund moving forward.
I believe that FEN continues to be an outstanding investment opportunity and one that will continue to reward investors with market-beating, double-digit shareholder returns and distributions in the years to come.
FEN focuses on the midstream energy industry, so I thought an overview of said industry, its investment thesis, and its overall performance might prove useful for readers and investors.
Energy Infrastructure Industry
The midstream energy industry, or energy infrastructure industry, encompasses the gathering, processing, transportation, distribution and storage of energy products, mostly crude oil, natural gas, NGLs, and assorted refined products. The typical company in the industry is a pipeline operator, transporting energy products from upstream oil producers to downstream refineries.
Energy Infrastructure Industry - Competitive Advantages
Energy infrastructure companies operate in a very capital-intensive industry. It generally takes tens of millions of dollars to build the necessary infrastructure to store, transport and distribute energy products, and billions to create a competitive network.
The capital-intensive nature of the industry functions as a wide economic moat for most energy infrastructure companies. Extremely few companies have the necessary capital to successfully compete in the industry; approximately none are willing to invest the necessary sums to undercut the competition.
Energy infrastructure companies are able to leverage their economic moats and competitive advantages to earn outsized revenues, earnings and cash flows, ultimately boosting shareholder returns and dividends.
As a quick example, take a look at the shareholder returns of Enbridge (ENB) and Enterprise Products Partners (EPD), the two largest companies in the industry by market cap. Both have significantly outperformed relative to the S&P 500, testament to the companies' strong competitive advantages:
Energy Infrastructure Industry - Regulatory Environment
Energy infrastructure companies operate in heavily regulated industries. Generally speaking, prices are set by government regulators and ensure that companies earn a reasonable rate of return, usually between 10% and 12% ROE. These same companies generally operate under long-term fee-based contracts with take-or-pay clauses, which charge minimum payments regardless of the actual usage or demand for their facilities. Contracts have very little direct commodity price exposure, so the financial performance of these companies is only very modestly related to commodity prices themselves.
As such, energy infrastructure companies tend to have incredibly stable revenues and earnings, which allows them to perform relatively well even under commodity price slumps and periods of significant market uncertainty. As an example, take a look at EPD's financial performance throughout the years. The company's earnings and cash flows have both grown throughout the years, even during past oil price crashes:
(Source: Enterprise Product Partners Investor Presentation)
Energy infrastructure companies have very stable revenues and cash flows and very little commodity price exposure. This is broadly beneficial for investors and of special importance to dividend investors, as it ensures that these companies are almost always able to cover their dividend payments.
Corporate Structures - Corporations and MLPs
Energy infrastructure companies are sometimes structured as master limited partnerships, or MLPs. There are several advantages and disadvantages to this structure, but for the purposes of this article, three things stand out.
First is the fact that MLPs generally have favorable but complicated tax treatment. FEN, as an MLP fund, neatly sidesteps most of these issues, but I'll be talking about the fund's tax situation in a bit more depth later in the article.
Second is the fact that most MLPs tend to trade at significantly larger discounts when compared to midstream corporations and sport much larger dividend yields to boot. Compare MLPA, which focuses on MLPs, with MLPX, which includes both MLPs and corporations. MLPA is currently sporting a much cheaper valuation, as do most MLPs:
(Source: Global X Corporate Website)
Third is the fact that most MLPs are high-risk investments, with weaker balance sheets, smaller economic moats, and more commodity price exposure, at least when compared to midstream corporations. MLPs trade at a discount for a reason.
Different analysts might have different opinions, but I believe that MLPs are a slightly superior corporate structure, due to their favorable tax treatment, but that most MLPs are inferior investments when compared to midstream corporations, due to their higher level of risk. Investing in both, for diversification purposes, seems like the reasonable thing to do.
Energy infrastructure companies are currently an outstanding investment opportunity as they have:
Strong yields, cheap valuations and favorable long-term outlooks combine to create a particularly strong investment thesis. Let's take a closer look at each of the points above.
Extremely Favorable Outlook
Midstream industry prospects are strongly dependent on conditions and production in the broader energy industry, and production is booming. The shale revolution, caused by the advent of fracking and related technologies, has caused U.S. energy production to skyrocket, has transformed the country into the world's top oil and natural gas producer, and a leading exporter of energy products as well.
Most importantly, most industry analysts, including the U.S. Energy Information Administration, expect further significant increases in production:
(Source: EIA Short-Term Energy Outlook - November 2019)
Consumption growth has been relatively low, so most of the increased production has been used to supplant current imports and exported to foreign markets. Analysts expect this trend to continue, so expect energy exports to skyrocket in the coming years:
(Source: EIA Short-Term Energy Outlook - November 2019)
Increased energy production and exports has led to a sustained capital buildup in the North American midstream industry, with record levels of CAPEX during 2019. More importantly, most analysts expect CAPEX to remain relatively high in the years to come, as the midstream industry expands to better distribute and transport all the aforementioned increased energy products:
A positive aspect for midstream companies is the fact that production growth is mostly dependent on the discovery and development of new shale formations and technological advancements. Energy prices themselves are only a small-to-moderate factor in the shale revolution, which means that midstream corporations are much less likely to underperform if commodity prices soften. To quote from a past EIA energy outlook:
Although world oil prices play a role in U.S. crude oil and natural gas production - resource availability and technological improvements are more significant determinants of domestic production levels
(Source: EIA Energy Outlook)
Massively increased production, CAPEX growth, and the resultant increase in revenues, earnings and cash flows sounds great, but things get even better. See, the EIA is a very conservative institution, with very conservative analysts and estimates. Due to this, their projections have tended to understate the actual radical impact that the shale revolution has had on the energy industry.
As a quick example, the EIA was projecting oil production of 10 million barrels a day for 2018, the actual result was 11 million barrels a day. Figures for previous years are similar.
In any case, these massive increases in energy production have led to outsized revenue, earnings, and cash-flow growth for most midstream energy companies. EPD, the largest midstream MLP, recently reported record earnings, with most companies in the industry reporting similar results:
(Source: Enterprise Product Partners Investor Presentation)
Midstream energy companies have reported record revenues, earnings, and cash flows, but also record lows. Due to a combination of bearish industry sentiment, slowing production growth, soft commodity prices, and end-of-year tax-loss selling, midstream prices have collapsed during the past few months. MLPs themselves are trading at historic lows, while midstream corporations are trading at significantly distressed levels:
Midstream valuations are also remarkably cheap, with both MLPs and midstream corporations trading at hefty discounts relative to their historical average and industry peers:
(Source: Alerian MLP Investor Presentation)
The midstream industry is currently offering one of the best value propositions in the market. Midstream investors can expect attractive shareholder returns moving forward, at least compared to those in the recent past. More importantly, midstream investors could earn outsized total returns if industry valuations recover. This is, admittedly, quite a big if, which brings me to my next point.
Strong Dividend Yields
Midstream energy companies are currently offering some of the strongest dividend yields in the market, both compared to the broader equities market, other high-yield investments, and to their historical averages. MLPs themselves currently offer a 10% distribution yield on average, and most of these distributions are growing quite rapidly. Midstream energy corporations currently offer a nice 6.6% dividend yield, lower but relatively good as well. Yields are significantly higher than those offered by the broader equities market, utilities or REITs:
Strong dividend yields are obviously beneficial for investors, as they both boost shareholder returns and ensure that shareholders will see reasonably good returns even if share prices remain stubbornly soft and valuations don't improve.
Investment Thesis Summary
Let's review. Midstream energy companies offer some of the strongest growth prospects, highest distribution yields, and cheapest valuations available in the market today. Shareholder returns have, however, significantly lagged behind actual financial performance and operational results, mostly due to bearish market sentiment and soft commodity prices.
In my opinion, the midstream energy industry makes for an outstanding investment opportunity but investors should focus on high-quality, low-risk companies and funds, especially those that have proven themselves able to navigate tough industry conditions.
Which is where FEN comes in.
FEN is an actively-managed leveraged closed-end fund, or CEF, focusing on the energy infrastructure industry. Some key metrics:
(Source: FEN Corporate Website - Chart by author)
FEN provides a simple way for investors to get exposure to the booming, undervalued midstream energy industry. FEN is a particularly strong fund in this industry due to its:
Strong shareholder returns, high distribution yields and distribution growth, and low risk and volatility are an incredibly strong investment thesis. Let's take a look at each of the points above.
Outstanding Investment Strategy
FEN's investment strategy is outstanding for three key reasons.
First is the fact that FEN invests in a wide assortment of energy infrastructure assets across North America, encompassing companies across the entire value chain, and across all relevant energy products. FEN is remarkably diversified for an MLP fund.
FEN focuses on MLPs, but also has sizable investments in midstream corporations, and some minor investments in defensive utilities and REITs:
Most funds in this industry, including the largest fund (AMLP) exclusively invest in MLPs. MLPs, as mentioned previously, tend to be relatively small, undiversified, high-risk, low-quality assets. Funds that invest exclusively in MLPs are, in my opinion, excessively risky and targeting an unreasonably small and high-risk market segment. As such, FEN's diversified holdings are a net benefit for the fund and its shareholders.
Second is the fact that FEN sells covered calls on many of its underlying assets. Selling covered calls is a low-risk options strategy that generates passive income, but slightly caps the fund's upside potential. FEN's options strategy is particularly appropriate for dividend investors and retirees, who should be willing to trade a bit of income for a small reduction in their upside potential.
Third is the fact that FEN has simply proven itself capable of making appropriate investment decisions and of creating substantial shareholder value during periods of significant market stress.
In this particular case, I think an example might be illuminating. If you take a look at FEN's latest semi-annual report, you will find that the fund's largest holding used to be cash:
(Source: FEN Semi-Annual Report)
Investment managers generally only hold significant amounts of cash if they are predicting an imminent market downturn and trying to time the market, and that is precisely what happened. Midstream energy valuations collapsed very shortly after FEN started amassing a cash position:
By holding such a large cash position, FEN was able to withstand that drop in midstream energy valuations and prices relatively easily and was able to leverage that dry powder by investing in the now cheaper, higher-yield MLPs and midstream energy corporations. As a result, FEN was barely affected by the recent drop in midstream prices and significantly outperformed its index:
FEN's investment strategy maximizes returns while minimizing risks and losses and has, as we shall soon see, been successful in delivering shareholder value and outperforming the competition.
Attractive, Market-Beating Total Shareholder Returns
FEN's successful investment strategy has let to outstanding shareholder returns across most relevant time frames. The fund consistently outperforms its peers in the MLP CEF industry by double digits and is almost always the top-performer in its peer group. Compare FEN's shareholder returns in the following table with those of its peer group:
Those are some extremely positive results. FEN's shareholder returns have been 6% higher than the industry average for the past decade. The difference is, if anything, widening, with the fund outperforming its competitors by over 30% for the past year! Outstanding results and a testament to the fund's successful and time-proven investment strategy.
FEN also consistently outperforms relative to midstream energy ETFs, especially during bear markets. Compare FEN's performance with that of four of the largest ETFs in the industry for the past three years:
FEN has, once again, significantly outperformed its peers. Extremely positive results for the fund and its shareholders, even more so when you remember that FEN is a leveraged fund that should be underperforming during bear markets. The fact that the fund and its investment managers have managed to achieve such outstanding results is, once again, proof of their successful and time-proven investment strategy.
FEN is also the only midstream energy CEF with positive price and NAV growth since inception, at least according to CEFConnect data. FEN has successfully navigated two commodity price crashes, the financial crisis, and several other periods of significant market stress and bearish sentiment, literally the only fund in the industry which has managed to do this.
FEN's performance looks great in no small part due to the fact that the midstream energy industry and most leveraged midstream/MLP funds have significantly underperformed for the past five years or so. Due to this, I decided to compare FEN to the broader equities market and energy industry. Results are as follows:
(Source: Seeking Alpha - Chart by author)
As can be seen above, FEN has performed quite a bit better than the energy industry, but worse than broader equities market. Results were perhaps not great, but reasonably good and significantly stronger than those of its peers.
(Source: Seeking Alpha - Chart by author)
In my opinion, the fact that all First Trust midstream energy funds have significantly outperformed relative to the competition is further evidence of the FEN's successful investment strategy. Simply put, I believe that First Trust's investment managers are very knowledgeable about this industry, which is why all of their funds perform so well.
Strong Dividend and Dividend Growth
FEN currently sports an incredibly attractive distribution yield of 11.40%, significantly greater than that of the broader equities market, energy and midstream industry, but roughly comparable to the lower-yielding MLP CEFs:
FEN's distribution track record is outstanding and significantly stronger than those of its peers. FEN has never once cut its distribution, unlike the vast majority of funds in the industry, and has actually managed to somewhat grow its distribution throughout the years:
(Source: Seeking Alpha - Chart by author)
FEN has one of the best distribution growth track record in this industry and is one of extremely few funds that has never cut its distribution since inception, a huge positive for the fund and its shareholders. It is also important to remember that FEN has accomplished the above and managed to grow its price and NAV since inception, an outstanding accomplishment.
Significantly Fewer Risks and Volatility
FEN's outstanding investment strategy and high-quality, low-risk holdings are particularly effective in creating shareholder value and alpha during periods of significant market stress. Take a look at FEN's performance during the past three months during which time midstream valuations have collapsed:
FEN significantly outperformed its peers; it wasn't even close. FEN's performance was similar during 2014-2016, during which oil prices collapsed by more than 50%:
I took a look at other periods of market stress, and the results are generally the same; FEN outperforms its peers during bear markets.
Outstanding results and rock-solid proof that FEN's investment strategy simply works at maximizing returns and minimizing losses.
Investment Thesis Summary
Let's review. FEN's outstanding investment strategy has led to market-beating total shareholder returns, a solid distribution growth track record, and is significantly safer and less risky than its peers. Low-risk, high-reward investment opportunities are few and far between, especially in a sector as beaten down as the midstream energy industry, but FEN definitely seems to fit the bill.
As mentioned previously, I said basically the same thing about FEN about a year ago, and well, results speak for themselves:
FEN was and remains an outstanding investment opportunity and a strong buy.
FEN might be a strong fund and investment, but it does have some drawbacks and risks.
Drawbacks - Valuation and Expenses
FEN's biggest drawback, in my opinion at least, is that the fund is incredibly expensive. The fund's 2.79% expense ratio is sky-high, and significantly greater than that of most index funds, and most actively-managed funds to boot.
Due to certain regulatory issues, FEN is treated as a corporation for income tax purposes and is obligated to pay federal, state, and foreign corporate taxes on its taxable income. Although this is somewhat common for funds in the midstream energy industry, it is a significant drawback for the fund and its investors. Being liable for corporate taxes puts the fund at a significant disadvantage when compared to the vast majority of equities funds and a couple of its peers as well.
FEN's other significant drawback is the fact that the fund isn't currently particularly cheap. It currently sports a modest 3.84% premium to NAV, slightly higher than average, but significantly greater than that of its peers, most of which trade at sizable discounts. In my opinion, FEN's benefits vastly outweigh this small premium, but it is obviously less than ideal, and a sizable drawback.
FEN's investors also face a series of significant risks:
FEN's outstanding investment strategy, market-beating total shareholder returns, strong distribution yield and track-record combine to make a low-risk, high-reward investment opportunity and an outstanding investment all-around. Investors looking for energy midstream funds should seriously consider including FEN in their portfolios, as it is simply one of the strongest funds in the industry.
As a final point, I wanted to revisit FEN as I had written about the fund before and as I thought it was the strongest fund in its industry. I still think it's an outstanding investment opportunity, but that some of the other First Trust midstream funds might be more compelling choices at current prices. I plan on taking a look at these other funds and selecting my top midstream energy fund for 2020 in the coming days.
I'm currently leaning towards the First Trust Energy Infrastructure Fund (FIF).
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This article was written by
Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.