XEL - UTG: The Panic Has Started

Summary

• UTG is a closed-end fund that mainly invests in utility companies. It has fallen nearly 26% from its August highs as the market priced in recessionary headwinds.
• We gleaned that the valuations of its leading holdings were too expensive in August and not sustainable. Moreover, we explain why utility analysts are still overly-optimistic.
• Therefore, we present our argument why the recent fallout is still too early for investors to buy the dips at the current valuations.
• Furthermore, we have yet to glean a robust bullish reversal price action. As such, investors should continue waiting on the sidelines for now.

Thesis

Investors in utility companies finally discovered over the past three months that even they would not be immune to the coming global recession, given their premium valuations.

Furthermore, we parsed that utility analysts have also been overly-optimistic over the earnings estimates of utility companies through 2023, with more estimates upgrades than downgrades through September. In contrast, analysts have been cutting estimates broadly on the S&P 500 companies through September. Therefore, utility analysts remain in denial over the prospects of demand destruction through the global recession.

While The Reaves Utility Income Fund's ( UTG ) exposure to leverage could enhance its performance, it could also impact its volatility, as seen recently. Furthermore, given the relatively high leverage of utility companies, they could be more significantly impacted in the rapid rate hikes environment, worsened by demand destruction from a potentially severe recession.

Notably, the market sent UTG into a steep decline since its recent August highs, down nearly 26% through October, emblematic of a rapid selloff. Therefore, we assess that its valuations have improved markedly. We assess the market has been pricing in worsening macro headwinds that could hurt the leading utility players.

However, we urge investors to continue waiting on the sidelines. We have yet to discern the bullish reversal price action that appeared at the end of past capitulation moves in UTG stanching further selling downside decisively.

As such, we rate UTG as a Hold for now.

UTG's Top Holdings Are No Longer Significantly Overvalued

With more than 77% of its holdings exposed to the utility sector, the overvaluation seen in its leading utility holdings was bound to be digested as we move closer to a recession. But we are surprised it had not happened sooner.

As seen above, the overvaluation in the top ten holdings of UTG (accounted for 44% of total exposure) has fallen markedly over the past three months. Its most expensive holding in this group, NextEra Energy ( NEE ), saw its NTM normalized PE fall from a high of 33.9x to 27.2x over the past three months. We also highlighted in a September NEE article urging investors to sell as it was too expensive, and we emphasized that its valuations were not sustainable. Accordingly, NEE has underperformed the broad market significantly since our update.

However, investors should not be complacent into thinking that UTG's top holdings look cheap now. They are still expensive, far from cheap, and still trade at a significant premium to the SPY (NTM PE of 15.1x) as we draw closer to a recession. Furthermore, we deduce the consensus estimates are still too optimistic.

Analysts have been revising the earnings estimates for the broad S&P 500 index downward, which accelerated through September. However, utility analysts were still optimistic, as more analysts posted upward revisions through September, as seen above.

However, as seen in past deep recessions in the early 2000s, GFC 2007-09, and 2020 COVID, utility stocks were not immune to significant downturns. As a result, investors shouldn't understate potentially substantial revisions in their earnings estimates

We believe further value compression is still likely at their current valuations as the market anticipates further headwinds to forward earnings.

Is UTG CEF a Buy, Sell, Or Hold?

Investors in UTG have certainly felt the steep selloff that sent its TTM distribution yield surging above 9%, well above the levels at its June lows.

Hence, we believe investors biding their time to add exposure could start to prepare their gear to go bear hunting. However, we urge investors to be patient for now. We note that the value compression in UTG has yet to find a sustained base or robust bullish reversal price action that preceded its previous recoveries from steep selldowns.

As such, we rate UTG CEF as a Hold and urge investors to continue observing from the sidelines.

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