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Exelon: Utility Selling At 10-Year Lows, Again

Exelon’s share price bottomed in 2013 at $26.91, rose to $36.83 in Aug 2014 and Dec 2014, only to drop to $26.60 this month. The long-term investment thesis remains the same. Exelon’s profitability is still dependent on competitive wholesale prices driven by natural gas pricing. Two years ago, almost to the day, I penned an article discussing Exelon (NYSE: EXC ) trading within a hair’s breath of its 10-yr low. Unfortunately, I can write a follow-up as this is the case again. It seems EXC is just as controversial today as it was back then, and uncertainty remains the major obstacle. New income investors looking for higher relative yields should review EXC and current shareholders should continue to hang in and even add to their position. In the previous article, the investment thesis was laid out: Management and investors are making a huge bet that demand will increase, wholesale pricing will increase, and base-load capacity will decrease. Demand will increase with strengthening economic activity in the Northeast and Midwest. Pricing will pick up with a turn in natural gas pricing. Base-load capacity will decrease as coal-fired plants are retired and as more intermittent-load wind replaces investments in additional base-load capacity. When these three events positively influence EXC’s bottom line, share prices will be substantially above their current 10-year lows. However, these events have not happened, and the timeframe continues to get pushed out. With the growth of natural gas as a generating fuel, electricity pricing continues to be influenced by the price of natural gas. As we know, natural gas is once again sub-$2.00, applying pressure on electricity pricing. Below are three graphs from sriverconsulting.com that tell the story. The first is the Forward Market price for electricity in ISO New England. The most recent forward price matches its 10-yr low of March 2012. The second shows the relationship of the 5-yr forward price of natural gas and electricity and the third shows the same relationship on a 1-yr basis. The last two charts demonstrate the correlation between natural gas pricing and electricity pricing, and the trend over the previous 12 months has been for tighter correlations. As of the week of Dec 9, the forward 12-month NYMEX price for natural gas was $2.34. (click to enlarge) Source: sriverconsulting.com (click to enlarge) Source: sriverconsulting.com (click to enlarge) Source: sriverconsulting.com Natural gas pricing will continue to be a key factor in PJM markets. According to ISO New England, in 2000, natural gas represented 15% of the fuel used to generate power in the Northeast, and this percentage grew to 44% in 2014. The growth has been at the expense of coal and oil, with these fuels declining from 18% to 5% and 22% to 1%, respectively. Nuclear remained almost constant at 31% and 34%. The following 17-yr chart shows the growth in MW capacity by fuel type in the Northeast, as offered by the ISO New England 2015 Regional Electricity Outlook. (click to enlarge) One advantage of merchant power generators in other parts of the US is many utilize 20-yr purchase power agreements with electric distribution utilities, usually including a “fuel cost plus” formulation. However in the Northeast, Mid-Atlantic and eastern Midwest, pricing is controlled by the Regional Transmission Organizations RTO, of which PJM Interconnect is the largest. The silver-lined underbelly of the auction process is the premium PJM now allows for “reliability,” and EXC’s nuclear generation qualify for these premiums. During the Polar Vortex of early 2014, power generation along the East Coast was dangerously close to falling under demand as frozen coal stocks and frozen natural gas valves caused an uncomfortably large amount of generating capacity being off-line. In response, PJM instituted an added premium for power generation with higher commitments to remain online, backed by huge fines for those who take the premiums but can’t deliver during similarly stressful times. Nuclear power, of which Exelon is the largest provider, is a qualified fuel for this premium. Over the next two years, this premium will be implemented and will help EXC realize a bit higher price for its commodity product. Demand and capacity retirements have been progressing along as expected, with additional nuclear plants announcing their retirement. Even after the acquisition of Pepco Holdings (NYSE: POM ), which is now expected to be EPS-neutral over the short-term, power generation sold mostly using the PJM 3-Yr Rolling Auction process will still represent about 50% of EXC’s earnings. While this exposure to the merchant market has declined from 80% in 2008, the graphs above have a large impact on earnings for EXC. Concerning the proposed merger with Pepco, management seems to have satisfied DC regulators with the move of some executives and their offices to the Washington area, along with $78 million in payments to DC customers. Exelon agreed to relocate 100 jobs from outside D.C. into the city and create an additional 102 union jobs. The company also agreed to co-locate its headquarters in D.C. Exelon has six months after the merger is approved to relocate elements of its corporate headquarters from Chicago to D.C. It will shift the primary offices of CFO Jack Thayer and Chief Strategy Officer William Von Hoene Jr. to D.C., as well as the entire Exelon Utilities division, which is now based in Philadelphia, along with divisional CEO, Dennis O’Brien. The merger could be finalized before management’s commitment to walk away if not completed by April 2016. Over the longer term, management estimates the merger can increase earnings by $0.25 a share over the next 4 years, or about 9% of the estimated $2.57 2016 EPS. Management believes the acquisition of Pepco will accomplish two important goals: the ability to fund the dividend entirely through its regulated businesses and the ability to gain sufficient critical mass to separate the regulated and unregulated businesses, if advantageous to shareholders. On a valuation basis, EXC offers an inexpensive entry point. Below is a comparison of fundamentals for EXC vs. the utility average, as offered by Morningstar.com: Source: morningstar.com, Guiding Mast Investments Consensus earnings estimate for next year have been increasing since June 2015. Below is a chart of 12-month consensus EPS estimates for 2015 and 2016, as offered by 4-traders.com. Insidermonkey.com wrote a positive article on EXC earlier this month. In summary: It’s been a down year for most utility companies as big mutual funds rotate out of the sector due to normalizing yields. Although Exelon Corporation shares are down 23% year-to-date because of the Great Rotation, Exelon’s decline has made it an attractive dividend play. Shares now yield 4.57% and trade at a reasonable 10.6 times forward earnings. Seeing as the company’s payout ratio of 0.55, Exelon’s dividend is secure and has room to expand given the company’s predicted next five year average EPS growth rate of 5.03%. Hedge funds are certainly bullish as the number of elite funds long the stock jumped by 10 during the third quarter. According to morningstar.com, in 2014, EXC’s total return was +39.9% while year-to-date total return has been a negative -23.0%. This compares to +20.3% and -11.3% for Diversified Utilities and +28.7% and -6.9% for the S&P Utility ETF (NYSEARCA: XLU ), respectfully. While the past 2 years have not been as profitable for EXC shareholders as the average industry investment, the current yield of 4.9% should be sufficient for income investors to buy and hold for the “eventual turnaround” in the same investment thesis outlined above. These 10-yr lows in share prices only come around every 10 years… or every 2 years in the case of EXC. Author’s note: Please review Author’s disclosures on his profile page.

Is DCA Ready To Bounce Back From Tax Loss Selling?

Summary This balanced closed-end fund has been hurt this year by its energy holdings. The 17% discount to NAV is higher than average due to tax loss selling. The high 10.9% distribution yield helps you earn alpha even if the discount does not narrow immediately. This is a good time of the year to look for closed-end funds that have been beaten down by tax loss selling. There is seasonal tendency for many of these funds to bottom out in late December and then rally the first few months of the next year. The Virtus Total Return Fund (NYSE: DCA ) was formed in February 2005. It is a global balanced fund that invests about 60% in equities and 40% in fixed income. The fund’s objective is total return, consisting of both capital appreciation and current income. (Data below is sourced from the Virtus website unless otherwise stated.) The equity portion of the fund invests globally in owners/operators of infrastructure in the communications, utility, energy and transportation industries. Its performance has been hurt this year by a 21% equity allocation to the energy sector including positions in Williams Companies (NYSE: WMB ), Kinder Morgan (NYSE: KMI ) and Enbridge (NYSE: ENB ) in the top ten holdings. The fixed income portion of the fund is designed to generate high current income and total return using extensive credit research. The fund managers seek to capitalize on opportunities across undervalued sectors of the bond market. About 43% of the fixed income allocation has been in corporate or emerging market high yield which has also hurt performance this year. The fund uses an option income strategy where it purchases and sells puts and calls, creating option spreads. The fund also uses leverage and borrows at short-term rates to invest at higher yields. There could be a good medium-term trading opportunity in DCA setting up from now until year-end because of tax loss selling. Over the last year, the average discount to NAV has been -12.42%, while it is currently around -17%. The 1-year discount Z-score is -1.58, which means that the current discount to NAV is about 1.5 standard deviations below the average. Source: cefanalyzer Five Year Historical Premium/Discount for DCA (click to enlarge) From an overall asset allocation perspective, DCA is similar to a global 60-40 balanced fund, but because of the leverage and sector concentration, it has higher risk than a typical balanced fund you would find at Vanguard or Fidelity. These were the asset allocation breakdowns as of Sept. 30, 2015: Equity Sector Allocation Breakdown Utilities 37.25% Energy 21.85% Telecommunications 18.58% Industrials 14.40% Financials 5.36% Consumer discretionary 2.56% Fixed Income Sector Allocations Corporate- High Yield 38.92% Corporate- High Quality 14.94% Bank Loans 11.55% Non-Agency Residential MBS 7.69% Non-Agency Commercial MBS 6.21% Mortgage Backed Securities 5.11% Asset Backed Securities 4.39% Emerging Market- High Yield 4.00% Yankee- High Quality 3.98% Non-USD 1.54% Treasury 1.52% Taxable Municipals 0.16% DCA has had about average long term NAV performance. But it may be good for a swing trade now because of the very high discount to net asset value. Since inception, it had big losing years in 2007 and 2008, and it is also struggling a bit this year. Here is the total return NAV performance record since 2006 along with its percentile rank compared to Morningstar’s World Allocation category: NAV Performance Table DCA NAV Performance World Allocation NAV Percentile Rank in Category 2006 25.40% 21.21% 100 2007 -41.41% 11.85% 100 2008 -66.08% -39.30% 65 2009 +27.75% +46.71% 91 2010 +48.54% +23.98% 25 2011 +6.29% -3.21% 13 2012 +15.29% +19.81% 78 2013 +13.12% +11.07% 56 2014 +13.60% +6.14% 20 YTD -4.98% -3.05% 64 Source: Morningstar The tables below are compiled as of September 30, 2015: Top 5 Countries United States 49.49% Canada 9.50% United Kingdom 8.43% Australia 5.10% France 3.91% Top 10 equity holdings Williams Companies, Inc ( WMB ) 3.62% Kinder Morgan Inc. class P ( KMI ) 3.57% AT&T Inc. (NYSE: T ) 3.36% Verizon Comm. (NYSE: VZ ) 3.28% Enbridge Inc. ( ENB ) 3.09% National Grid Plc (NYSE: NGG ) 2.87% NextEra Energy, Inc. (NYSE: NEE ) 2.66% Crown Castle Intl. (NYSE: CCI ) 2.25% Transurban Group Ltd. ( OTCPK:TRAUF ) 2.23% Atlantia S.p.A ( OTCPK:ATASY ) 2.13% Fixed Income Ratings Distribution Aaa 8.74% Aa 3.34% A 5.34% Baa 27.87% Ba 23.00% B 18.96% Caa 8.74% Not Rated 3.61% Fund management DCA is run by a team of three portfolio managers. All three managers have been with the fund since 2011. Connie Luecke, CFA Industry start date: 1983 Randle Smith, CFA Industry start date: 1990 David L Albrycht, CFA Industry start date: 1985 Alpha is Generated by High Discount + High Distributions The high distribution rate of 10.90% along with the 17% discount allows investors to capture alpha by recovering some of the discount whenever a distribution is paid. The fund has been paying a $0.10 quarterly distribution since April, 2014. Whenever you recover NAV from a fund selling at a 17% discount, the percentage return is 1.00/ 0.83 or about 20.5%. So the alpha generated by the 10.90% distribution is computed as: (0.1090)*(0.205)=0.0223 or about 2.23% a year. Note that this is more than the 1.58% baseline expense ratio, so you are effectively getting the fund managed for free with a negative effective expense ratio. Here are some summary statistics on DCA: Virtus Total Return Fund ( DCA ) Total Assets: 173 Million Total Common assets: 122 Million Annual Distribution (Market) Rate= 10.84% Last Regular Monthly Distribution= $0.10 (Annual= $0.40) Fund Baseline Expense ratio: 1.58% Discount to NAV= -17.08% Portfolio Turnover rate: 56% Effective Leverage: 27% Avg. 3 month Daily Volume= 75,964 (Source: Yahoo Finance) Average Dollar Volume = $280,000 DCA is a moderately liquid stock and usually trades with a bid-asked spread of one cent. You can often get some price improvement on marketable limit orders and buy or sell between the bid-asked spread. Because the price is so low, some care should be taken when trading DCA. DCA appears to be an attractive purchase for a swing trade at current levels with a discount to NAV of 17%, if you believe that the underlying portfolio has potential to bounce back from tax loss selling early next year.

Looking For REIT ETFs? Only 2 Of These 3 Should Be On Your Watch List

Summary These ETFs offer respectable dividend yields by investing in REITs. I see VNQ as the top ETF in the batch, but if either were to beat VNQ over the long term I think IYR has a better chance of doing. Due to similarity of holdings between VNQ and FRI, it would be difficult for FRI’s underlying assets to outperform VNQ’s assets by enough to cover the expense ratio difference. One of the areas I frequently cover is ETFs. I’ve been a large proponent of investors holding the core of their portfolio in high quality ETFs with very low expense ratios. The same argument can be made for passive mutual funds with very low expense ratios, though there are fewer of those. In this argument I’m doing a quick comparison of a few domestic equity REITs ETFs that investors may be contemplating. Ticker Name Index IYR iShares U.S. Real Estate ETF Dow Jones U.S. Real Estate Index VNQ Vanguard REIT Index ETF MSCI US REIT Index FRI First Trust S&P REIT Index ETF S&P United States REIT Index Dividend Yields I charted the dividend yields from Yahoo Finance for each portfolio. While IYR and VNQ are both yielding a little over 3.65%, the yield on FRI appears substantially lower. Since the yield was so weak I decided to look up the dividend history on Yahoo Finance and manually calculate it. Occasionally this results in a different value than the reported trailing yield. It isn’t common, but I wanted to double check some REITs ETFs will usually have higher dividend yields. There was no mistake that I could find. Expense Ratios The expense ratios run from .12% to .50%: VNQ is one of the cheapest REIT ETFs available. That is the reason I started building my own portfolio’s REIT allocation by buying up shares of VNQ. The combination of a very high yield and a low expense ratio made VNQ a natural choice for my portfolio. Strategy Earlier in the article I referenced which index each ETF would cover, but that doesn’t tell investors a great deal about how the individual allocations are created. Normally I would focus on comparing factors like the sector allocations of each ETF, but that wouldn’t make any sense when each ETF will simply be listed as being 100% invested in real estate. Fact Sheets To learn more about the ETFs, I pulled up the fact sheets for each: IYR’s Strategy Ironically, IYR does not explain their strategy in either the fact sheet or the general page on the ETF . I loaded up the prospectus on the ETF and finally found some answers. The fund managers use “a passive or indexing approach to try to achieve the Fund’s investment objective.” It is helpful to know that the fund is being passively managed, but it makes me wonder about the expense ratio. When the ratios are over .40% I usually expect to see some form of active management either in the portfolio or some rebalancing to follow an index that is changing significantly. The first response not being able to find the information I wanted in any of the three sources might be to look up the Dow Jones U.S. Real Estate Index, so I did that. It turns out that the Dow Jones Real Estate Indices do not include a single index with that precise name. Instead, they include several indexes with similar names. (click to enlarge) Without knowing precisely which of these indexes is being tracked, I don’t see a solid method to enhance the research. VNQ’s Strategy VNQ uses a passively managed, full-replication strategy and their index covers two-thirds of the REIT market. The fund’s management seeks to minimize their net tracking error by having a very low expense ratio. For investors that are not familiar with the net tracking error, it refers to the difference between the results of the ETF and the results of the index. A REIT is only eligible for inclusion in the index if it has a market capitalization of at least $100 million. RFI’s Strategy While the fact sheet does not discuss the strategy of the fund directly, they do discuss the index which gives us some insight. The index is maintained in a manner that includes implementation of daily corporate actions, quarterly updates of significant events, and the portfolio is reconstituted on an annual basis in September. The index appears to be passively managed as over each period the fund is lagging the index by a hair over the expense ratio. (click to enlarge) This is about how a passively managed fund should look when investors compare the NAV performance of the fund with the underlying index. An actively managed fund would miss by more significant amounts which could be outperforming the index or trailing it. Holding Similarity Since I’m seeing passively managed ETFs with materially different expense ratios, I wanted to determine how reasonable it would be for a substantial difference in performance. I checked the holdings of each ETF. The top holding across all 3 is Simon Property Group (NYSE: SPG ). It ranged from 7% to 8.35% of the holdings depending on which ETF I was looking at. VNQ and F had precisely the same top four holdings in the same order, though the percentage allocations varied slightly. Number two is Public Storage (NYSE: PSA ). Number three is Equity Residential (NYSE: EQR ). Number four is AvalonBay Communities (NYSE: AVB ). When the holdings are similar and the strategy is passive it is difficult to find any reason to expect the underlying portfolios to have materially different returns. IYR on the other hand did offer some different allocations. The second allocation there is American Tower Corp. (NYSE: AMT ) which is a REIT that operates cell phone towers. They are working in an oligopoly as there are only a few major cell phone tower REITs and the leasing structure on their facilities results in enormous economies of scale when they are able to increase the number of customers for each location. AMT is not in the top 10 holdings for either of the other REIT ETFs. Conclusion I tend to favor very passive management which is the trend for each of these ETFs. Without a compelling reason to pick either of the ETFs with a higher expense ratio, I see VNQ as the strongest REIT ETF in this batch. If IYR or FRI were to outperform VNQ over the longer term, I would expect it to be IYR because there appears to be a larger difference in the selection of securities which should reduce the correlation in the long run returns of the ETFs.