UTF Vs. Duke Energy: If You Must Buy Utilities, Buy UTF | Seeking Alpha

2022-08-20 07:07:42 By : Ms. Michelle Jiang

Dilok Klaisataporn/iStock via Getty Images

Dilok Klaisataporn/iStock via Getty Images

We follow a top-down investment approach. We first check the market at a sector level to see the forest and then check a few leading stocks to see the trees. The following is what we see at the sector level. With the 10-year treasury rates pushing toward 3%, many "safe" sectors and stocks such as utilities and consumer staples are no longer safe, as you can see from our market dashboard below. The utility sector is actually the most expensively valued sector relative to the risk-free rates. The mechanics of the market dashboard are detailed in our earlier article here and you are welcome to download it here.

Next, we also want to check things out at the individual stock level. Sometimes, the sector is expensive only because a few individual stocks are so outrageously overvalued. But it is not the case here. As we just analyzed in an earlier article, the leader in the utility sector, NextEra Energy (NEE), is even more overvalued than the sector. Today, we will check out another leader in the utility sector, Duke Energy (NYSE:DUK ), and compare it with the Cohen&Steers Infrastructure Fund (NYSE:UTF ). DUK is the second largest electricity holding in UTF (NEE is the largest). And our thesis is that:

Next, we will review some basics and highlights of UTF and DUK, and then elaborate on the above thesis.

The UTF fund invests in securities issued by infrastructure companies, with an emphasis on income. The fund is top-heavy. The top 10 holdings are listed below, and they represent ~35% of the total net asset, more than one-third. And as you can also see, the top holding is NEE (mainly an electricity company). And as aforementioned, it is even more overvalued than the sector. And 4 of the top 10 holdings are electricity companies, with DUK being the 3rd largest electricity holding. The other 6 top holdings span a wide spectrum including toll roads, rails, et al, providing diversification across a wider range of sub-sectors.

Source: Cohen&Steers fund description

Source: Cohen&Steers fund description

DUK is a holding company for utilities with 7.6 million electricity customers. It posted strong performance and an exceptionally productive 2021. As CEO Lynn Good commented:

We’re leading the industry’s largest clean energy transformation with more than 80% of our $63 billion capital plan funding investments in grid modernization and zero or lower-carbon emitting generation. These investments position us to earn solidly within our 5% to 7% EPS growth range throughout our five-year plan.

And a few highlights quoted from its earnings report (chart provided below):

Source: DUK 2022 Feb earnings report

Source: DUK 2022 Feb earnings report

The first reason against buying utilities now is the rising interest rates.

Utilities have been helped by the secularly low-interest rates in the past decade. And now interests are on the rise and will pose a headwind. All utilities heavily depend on delta financing (and hence utility funds like UTF depend on debt financing too, subsequently). And rising rates will cause increased interest rates and pressure their profits. Admittedly, utilities have shown the ability to pass part of the increases in borrowing onto customers - but only partially. As you can see from the chart below, the profits of the UTF fund (measured by its dividend payments) have been in negative correlation with the interest rates in the long term - meaning when interest rates increased, its dividend payments decreased.

An effective way (and in my mind the only reasonable way) for valuations is to evaluate valuation against risk-free interest rates. This work will use the dividend yield spread against risk-free interest rates as a valuation measure. Details of these concepts and approaches have been provided in our earlier article. Dividend yields and yield spread are what we first check before making any investment decisions. We've fortunately had very good success with this approach because of:

With this background, you will see below that when adjusted for interest rates, both UTF and DUK's current valuations are at the most expensive level relative to risk-free rates in a decade.

The first chart below shows the yield spread between UTF and the 10-year treasury in the long term. The dividend yield is calculated based on the TTM dividends. As can be seen, the spread is bounded and tractable. Except for the period before 2013, when the overall market is undervalued and pretty much any equity is a good deal, the spread has been in the range between about 4.3% and 8.5%. Suggesting that when the spread is near 8.5%, UTF is significantly undervalued relative to 10-year Treasury bond (i.e., I would sell Treasury bonds and buy UTF). And when the yield spread is near or below 4.3%, it means the opposite.

Now the spread is about 3.7%, again, the thinnest level in more than a decade. The picture for DUK is very similar (and even worse) as you can see from the second chart below.

Finally, for readers familiar with our analyses, you know that the short-term returns are closely correlated with the yield spread for funds or stocks that have demonstrated stable earning power and dividends. It is also true for UTF and DUK. The chart below shows the one-year total return (including price appreciation and dividend) from DUK when the purchase was made under different yield spreads. You can see that there is a clear positive trend, and the Pearson correlation coefficient is 0.44. The picture for UTF is very similar and wouldn't be repeated over here. The Pearson correlation coefficient is even a bit higher for UTF at about 0.52.

Finally, if you must hold utility, we see UTF as the lesser evil here, for a few reasons.

Both the UTF fund and DUK have delivered solid total returns in the past as you can see from the first chart below. However, as an actively managed fund, UTF has delivered superior performance (and the alpha is almost 1% CAGR in the long term). It features a proven management team that has demonstrated a good track record in the past. Although, note that part of the outperformance was due to the use of leverage. And as a result, the fund has suffered larger volatilities in terms of standard deviation, worst year performance, and maximum drawdowns. If you are long-term-oriented, such volatilities do not matter much. Otherwise, they can hurt you both financially and emotionally.

As aforementioned, both the UTF and DUK now feature the thinnest yield spread relative to risk-free interest rates. However, in relative terms, UTF provides a relatively lower risk premium. The yield spread Z-score for UTF is negative 1.28, and it is even more negative for DUK at about negative 2.0.

UTF also provides better diversification in terms of sub-sections and geographical exposure. Electric utility is the largest exposure, at 33%. And the next largest sector is midstream C Corp at 11%, followed by corporate bonds, freight rails, towers, toll roads, et al. So overall, even though there is heavy emphasis on electricity, the fund provides diverse exposure to various infrastructure sub-sectors. In terms of geographical diversification, the fund's largest exposure is the United States at 58% (and the rest 42% of its exposure is ex-US). The second-largest country exposure is Canada at 13%, followed up by Australia at 5%.

Finally, UTF provides much higher current dividends for better investment support. As you can see from the second chart, UTF provides consistently higher current dividends than DUK. And in 2022 so far, its dividend payments are about 3x of those from DUK.

Now is the worst time to buy the utility sector in a decade. Both the sector (represented by UTF) and its leading stocks are at their most overvalued levels relative to risk-free interest rates in a decade. Rising interest rates will also pressure their bottom lines because of higher borrowing costs.

However, if you must hold utility, we see UTF as the lesser evil here. It features a relatively lower risk premium relative to risk-free interest rates. The yield spread Z-score for UTF is negative 1.28 and is negative 2.0 for DUK. UTF also provides better diversification in terms of sub-sections and geographical exposure.

There are also a few other risks to consider as detailed in my earlier article:

As you can tell, our core style is to provide actionable and unambiguous ideas from our independent research. If your share this investment style, check out Envision Early Retirement. It provides at least 2x in-depth articles per week on such ideas.

We have vetted and perfected our methods with our own money and efforts for the past 15 years. For example, our aggressive growth portfolio has helped ourselves and many around us to consistently maximize return with minimal drawdowns.

Lastly, do not hesitate to take advantage of the free-trials - they are absolutely 100% Risk-Free.

This article was written by

** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

Department of Mechanical Engineering, with concentration in  advanced and renewable energy solutions

** 15 years of investment management experiences 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Diverse background and holistic approach 

Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities. 

I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.

Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.