FEN: Not A Good Value Today

Summary

  • FEN is one of the more popular midstream closed-end funds on the market.
  • The fund is reasonably well-diversified, although it does appear to be betting pretty heavily on a recovery in the demand for refined products.
  • The long-term fundamentals for midstream companies are reasonably positive despite the Biden Administration's hostility towards them.
  • The fund appears to be overdistributing as its NAV declined in both 2020 and 2019, one of which was a good year for the industry.
  • The fund appears to be overvalued at the present price.
  • This idea was discussed in more depth with members of my private investing community, Energy Profits in Dividends. Learn More »
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Midstream companies have long been favorites of income investors for a very good reason. These companies tend to enjoy very high yields and relatively stable cash flows. This is a direct result of the business models that they use, which typically insulate from economic fluctuations. The recent pandemic showed us though that some of these companies are better than others. Thus, it can sometimes be challenging to put together a portfolio of the best companies in the industry. One solution to this is to invest in a closed-end fund that specializes in the sector and gain the advantage of professional management as well as potentially higher yields than what one could obtain on their own. In this article, we will look at one of the more popular such funds, the First Trust Energy Income & Growth Fund (NYSE:FEN), which currently yields an impressive 8.08%. I have discussed this fund before but a few months have passed since then so in this article, we will specifically focus on the changes that have taken place in the interim as well as have an updated look at the fund’s finances.

About The Fund

According to the fund’s web page, the First Trust Energy Income & Growth Fund has the stated objective of generating a high level of after-tax total return. This is not exactly unusual as nearly all common equity funds state a somewhat similar objective. The thing that sets this fund apart from many other closed-end funds is that its strategy specifically focuses on investing in cash-generating securities of energy companies, which have a heavy focus on master limited partnerships. This is somewhat unusual as very few funds focus specifically on master limited partnerships due to regulatory reasons. Master limited partnerships are well-known for boasting very high yields though, so this is something that could prove quite appealing to income investors.

As my regular readers certainly know, much of my past research has specifically focused on midstream companies and master limited partnerships. As such, the largest positions in the fund will likely be familiar to regular readers:

Source: First Trust

This list includes many of the largest midstream companies in the United States and Canada and I have discussed most of them in past articles. Several of the firms on this list are the same as they were the last time that we looked at the fund but the weightings have changed. For example, Magellan Midstream Partners (MMP) remains the largest position in the fund, although it only accounts for 9.27% of total assets as opposed to 10.56% previously. Magellan Midstream is something of an economic rebound play due to its focus on refined products. As refined products are primarily used in the transportation industry, the demand for them obviously fell during the lockdowns. The American economy has since begun to reopen and the demand for these products has begun to return to normal. Thus, this has resulted in the expectations that Magellan may have some upside potential as the economy returns to normal and the demand for refined products returns. This may be the theory that the fund’s management is operating on.

The market pummeled the price of midstream companies last year when crude oil prices collapsed. However, these companies are generally insulated against commodity price declines. This is the business model that these firms use. In short, these companies provide their services to customers under long-term contracts that include something called a minimum volume commitment. These companies earn their money by charging a fee for each unit of product that moves through their pipes, not on the value of the product, and the minimum volume commitments specify a certain minimum volume of resources that must be sent through the pipes or paid for anyway. This provides these companies with generally stable cash flow regardless of what commodity prices do. The exception to this is refined products as these contracts do not include minimum volume commitments. This is why Magellan Midstream’s cash flows were somewhat more impacted by the downturn than some of its peers and why it may have somewhat more upside than some of its peers as the economy returns to normal.

As my long-time readers on the topic of closed-end funds are well aware, I generally do not like to see any single position account for more than 5% of the fund’s total assets. That is because this is approximately the level at which that asset begins to expose the fund to idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk which any asset possesses that is independent of the market as a whole. This is the risk that we aim to eliminate through diversification but if the asset accounts for too much of the portfolio, then the risk will not be completely diversified away. Thus, the concern is that some event may occur that causes the price of that asset to decline and if the asset accounts for too much of the portfolio, then it could end up dragging the entire portfolio down with it. As we can see above, there are four assets that each account for more than 5% of the portfolio, one of which accounts for nearly double that. As such, any potential investor should be willing to be exposed to these positions individually before taking a position in the fund. This sort of heavy concentration in only a few positions is not exactly uncommon for a midstream fund as most of them have something similar.

There are several different types of midstream company, differentiated by the types of products that each carry. This proved to be important last year as some products saw demand hold up better than others. An easy example of this is that the demand for refined products proved less resilient than the demand for natural gas. This is because natural gas was still needed as a heating and cooking fuel but the lack of travel meant that refined products were not needed as much. Thus, it is somewhat nice to see that the fund’s assets are fairly well distributed across all of the different types of midstream companies:

Source: First Trust

Without a doubt, the most surprising thing to see here is the significant exposure to electric utilities. Indeed, these entities are the second-largest single position in the fund. These are commonly found in midstream funds, although they are not usually considered to be midstream companies. They do have many similar characteristics though such as generally stable cash flows and higher dividend yields than most other companies. These companies also provide a certain amount of exposure away from fossil fuels, which is going to be important for those that are looking to “go green.” The stock prices of utilities held up much better than the stock prices of midstream companies during the worst of the pandemic, which could help add some stability to the fund.

The Fundamentals Of Midstream

There are some investors that have become concerned with regards to midstream companies since the start of the year. This is partially due to the hostility that the Biden Administration has shown towards these firms, such as the cancellation of the permits for the construction of the KeystoneXL pipeline. This order actually had minimal impact on midstream companies other than TC Energy (TRP), which is constructing it and currently suing the U.S. government to recover the money that it has already invested in the project. The Administration’s stay on new drilling permits is also unlikely to have an impact since companies are still able to use their existing permits and the executive order has no impact on private lands. Thus, the general fears surrounding the industry are quite unfounded.

There are in fact some reasons to believe that the future of the industry is quite bright. This is because the global demand for fossil fuels is expected to grow going forward. This is particularly true with regards to natural gas, which will perhaps surprisingly benefit from the growing fears about climate change. This is because natural gas burns much cleaner than other fossil fuels and is more reliable than renewables. Thus, many electric utilities around the world have been working to reduce the use of coal in their power plants and using natural gas instead in order to reduce their carbon emissions and still maintain the stability of the grid. The International Energy Agency expects that this trend will continue and cause the global demand for natural gas to increase by 29% over the next twenty years:

Source: International Energy Agency, Pembina Pipeline (PBA)

We can also see that the demand for crude oil is expected to increase going forward but not by nearly as much as natural gas. This growth will come from emerging markets, which are expected to see growing wealth over the period. As these economies grow, the citizens will become wealthier and move from poverty into the middle class. As this process unfolds, these people can be expected to want a lifestyle that is closer to what their developed nation counterparts have than what they have now. This will require growing amounts of energy, including crude oil. These countries have higher populations than their developed nation counterparts do. Thus, their rising consumption will overpower the stagnant to falling consumption in developed nations.

This will all benefit the nation’s various midstream companies. This is largely due to the United States being one of the few nations that has the ability to significantly increase its production of crude oil and natural gas due to the wealth of regions like the Permian basin and Marcellus shale. We can thus expect the nation’s fossil fuel producers to increase their production in order to meet this demand. This incremental crude oil will need to be transported to the market in order to be sold. This should result in rising volumes of resources moving through the pipes and by extension higher cash flows for these companies.

Distribution Analysis

As mentioned earlier in the article, one of the biggest reasons that investors purchase shares in midstream companies is the incredibly high distribution yield that these companies typically pay out. As such, we might expect the First Trust Energy Income & Growth Fund to boast a very high yield. This is indeed the case as the fund pays out a regular quarterly distribution of $0.30 per share ($1.20 per share annually), which gives it an 8.08% yield at the current price. This current distribution is the result of a cut that the fund made when the pandemic caused crude oil prices to crash. The fund’s distribution history was highly positive prior to this:

Source: CEF Connect

Admittedly, the distribution cut last year may make this fund somewhat unattractive to income-focused investors. However, most funds focused on the sector ended up cutting their distributions in response to the unprecedented crash in oil prices that created a great deal of uncertainty in the industry. We also saw midstream companies like DCP Midstream (DCP) cut their distributions in response to this, although all of these companies generally saw their cash flows hold up okay. The distribution cut is not the only thing that may concern potential investors though. Another thing that might is that the distributions are entirely classified as return of capital:

Source: Fidelity Investments

The reason why this may be concerning is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. This is obviously not sustainable over any kind of extended period. However, the distributions made by a master limited partnership are also classified as return of capital so this could simply be the fund distributing the money that it receives from the partnerships that are in its portfolio. As such, we should investigate to determine how exactly the fund is financing these distributions in order to determine how sustainable they are likely to be.

Unfortunately, the most recent financial report available for the fund is for the full-year period ended November 30, 2020. As this largely predates the recovery that we saw in the industry following the presidential election, it will not reflect the almost certain improvements that the fund has seen in its finances since that time. It may still give us some insights into the source of the fund’s distributions, however. During that full-year period, the First Trust Energy Income & Growth Fund received a total of $3,400,928 in dividends and $11,967 in interest off of the investments in its portfolio. This gives the fund a total income of $3,412,895 during the year. This alone was not enough to cover its expenses and the fund had a negative net investment income of $8,032,432, which obviously does not look good for the distribution. It is important to keep in mind though those distributions that it received from master limited partnerships do not count as income but as return of capital that becomes capital gains depending on the sale price when the fund finally sells its positions. The fund unfortunately does not disclose exactly how much it received from these companies but overall it had a net realized and unrealized loss of $96,753,786, which is not surprising considering the performance that midstream companies delivered during that period. Despite the capital losses and negative net investment income though, it still distributed $35,208,712 to its investors.

Naturally, 2020 was a remarkable year as it was the first time that governments all over the world shuttered their economies in response to a pandemic. The fact that the fund could not afford its payouts would not be a big deal if it can make up for the losses in a more normal year. This was unfortunately not the case. As you may recall, 2019 was a fantastic year for the energy industry but the fund still saw its net assets decline. On October 31, 2018, the fund had $425,112,548 in net assets but this was down to only $249,523,862 as of November 30, 2020. This capital destruction is very disheartening and certainly explains the massive distribution cut that we saw in 2020.

Valuation

As is always the case, it is critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate suboptimal returns off of that asset. In the case of a closed-end fund, the usual way to value it is by looking at a metric known as net asset value. The net asset value of a fund is the total current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately 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 implies that we are acquiring the fund’s assets for less than they are actually worth. That is not the case here. As of July 8, 2021 (the most recent date for which data is available), the First Trust Energy Income & Growth Fund had a net asset value of $14.75 per share but actually trades for $14.85 per share. This represents a 0.68% premium to net asset value, which is substantially higher than the 1.89% discount that the fund has averaged over the past month. Overall, this fund does not look like a good value at the current price, particularly given its history of capital destruction over the two-year period.

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