DNP - DNP: Still Too Expensive

2023-04-17 05:29:35 ET

Summary

• DNP is a leveraged utilities CEF.
• The fund is incredibly popular in retirement circles, due to its strong, stable 7.4% distribution yield, and high-quality holdings.
• It also tends to trade with a significant premium, with all the negatives that entails.

The DNP Select Income Fund ( DNP ) is a leveraged CEF focusing on utilities, a relatively low-risk, high-quality industry. Although DNP has several positives, the fund currently trades with a massive 18.6% premium to NAV, an incredibly significant negative. Such a sizable premium could result in double-digit capital losses for investors, and moderately reduces yields and returns regardless. In my opinion, DNP's 18.6% premium to NAV is excessively high, and so I would not be investing in the fund at these prices.

DNP - Quick Overview and Benefits

DNP is an actively-managed, leveraged CEF focusing on utilities, with smaller investments in bonds and other fixed-income securities, as well as MLPs. The fund is reasonably well-diversified, with investments in hundreds of securities, and not terribly concentrated either. Asset allocations and largest holdings are as follows.

DNP is a leveraged fund, with an effective leverage of 25.6%, about average for a CEF. Leverage increases risk, volatility, and potential losses during downturns. Expect DNP to underperform during the latter, as was the case in 1Q2020, the onset of the coronavirus pandemic.

Excessive leverage can lead to outsized, unrecoverable losses during deep downturns. Leveraging very risky assets can have the same effect. In my opinion, DNP is not excessively leveraged, nor are the fund's assets (utilities) very risky. As such, the fund's leverage does not excessively increase risk or potential losses, in my opinion at least.

DNP offers several benefits to investors. Three stand out.

First, is the fund's relatively safe, high-quality utilities investments. Utilities tend to be heavily regulated by the government, which ensures stable, and growing, revenues and cash-flows. DNP focuses on utilities, and so shares these same characteristics. On a slightly more negative note, for utilities, growth tends to be lower than average, and dependent on CAPEX. This somewhat reduces potential returns, and the probability of outsized gains.

Second benefit is the fund's 7.4% distribution yield. It is a strong yield on an absolute basis, much higher than that of most equity indexes and utility indexes. It is also reasonably sustainable in the long-term, as evidenced by the fund's long-term NAV sustainability or trajectory.

On a slightly more negative note, NAVs have slightly declined since inception, which negatively impacts income and distribution sustainability. Distributions could start to decrease too, although as NAVs have declined very slow, I'm not seeing significant short-term risk here.

Third benefit is the fund's strong long-term performance track-record, with DNP outperforming its index on both a NAV and price basis since inception.

On a more negative note, DNP's more recent performance is somewhat weaker, somewhat uneven. The fund sometimes outperforms, sometimes underperforms, on both a NAV and price basis. DNP does not currently consistently outperform, even though that might have been the case in prior years. As an example, the fund's 1Y performance.

DNP's comparatively safe utilities holdings, strong 7.4% distribution yield, and solid performance track-record are all incredibly beneficial for the fund and its shareholders.

DNP - Premium Analysis

DNP seems like an outstanding investment opportunity, in my opinion, and in the opinion of many readers and investors. Importantly, the market as a whole seems to agree, with the fund consistently trading with a double-digit premium to NAV. DNP's premium reached over 30% in prior weeks, but has fallen to 18.6% these past few days. The premium remains very elevated on an absolute basis, and somewhat elevated on a historical basis.

DNP's excessive premium is a significant negative for shareholders for two key reasons.

First, is the fact that an excessive premium exposes investors to excessive potential losses, contingent on premiums normalizing. Investors are looking at +8.0% in capital losses premiums go down to around 10%, or January 2022 levels. Investors could see double-digit losses if premiums drop to the single-digits, or 2017 levels. Single-digit premiums are somewhat rare for DNP, but not unprecedented.

Second issue with the fund's premium, is the fact that these reduce its distribution yield. Specifically, and as per my calculations, if the fund traded at NAV it would sport a distribution yield of 8.6%. It trades at a sizable premium to NAV, which decreases its yield to 7.3%. In effect, the fund's excessive premium reduces its yield by 1.3%, directly reducing shareholder income and returns. The reduction is large enough that underperformance is likely: very few funds are able to consistently generate 1.3% in alpha, including DNP. As the fund is unlikely to produce sufficient excess returns to overcome its reduced yield, underperformance is likely. Importantly, these issues impact shareholders regardless of any movement (or not) in the fund's premium.

As an example, DNP's premium remains (roughly) unchanged these past five years.

During that time, the fund saw NAV returns of 57.2%. Shareholders, on the other hand, saw returns of only 45.9%, for a performance gap of 11.4%. Said gap was almost entirely caused by shareholders receiving comparatively lackluster distributions from the fund. DNP underperformed its benchmark too, in large part due to decreased distributions.

DNP would have to outperform its index on a NAV basis by a healthy margin for shareholders to break-even on a price basis. Outright outperforming would require very hefty margins, which DNP has failed to achieve for years. DNP's excessive premium all but ensures shareholder underperformance moving forward, as has been the case these past few years.

Conclusion - Sell

DNP's excessive 18.6% premium makes the fund a sell.

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