PEY Remains Attractive As Long As Rates Stay Low – Invesco High Yield Equity Dividend Achievers Portfolio ETF (NASDAQ:PEY)

Main Thesis

The purpose of this article is to evaluate the Invesco High Yield Equity Dividend Achievers ETF (PEY) as an investment option at its current market price. This is a fund I recommended when 2019 got underway, and it turned out to have been a profitable call. With a double digit return, PEY is actually beating the Dow Jones Index since the new year started, and only lags the S&P 500 by a few percentage points. Considering the defensive nature of the fund, that is pretty strong performance. Looking ahead, I see some reasons to remain invested in PEY. The dividend continues to grow, albeit modestly, and the yield remains attractive. Furthermore, profit margins among utility companies have been rising, which helps PEY specifically as the Utilities sector is the fund’s largest sector by weighting. Also importantly, the Fed has not raised rates at all so far this year, and investors expect rates to remain unchanged for the remainder of 2019. While these are all bullish points, PEY’s attractiveness does depend on a dovish Fed and continued strength in defensive sectors, which are getting pricey based on historical valuations. This tells me investors should be cautiously optimistic on PEY at this time.

Background

First, a little about PEY. The fund is “based on the NASDAQ US Dividend Achiever 50 Index. It is comprised of 50 stocks selected principally on the basis of dividend yield and consistent growth in dividend”. It is currently trading at $18.15/share and yields 3.66% annually, based on the last twelve distributions. I recommended PEY when I reviewed it for the first time back in January, and the fund has seen strong performance since then. In fact, PEY is up almost 11% since that time, after accounting for distributions. While buying in January would have clearly been a profitable move, it is important to consider that the broader market is also up quite a bit over the same time period. Therefore, I wanted to reassess PEY to see if it still makes sense to own going forward. I believe it does, and I will explain why in detail below.

Monthly Dividend Still Looks Good

During my January review, I highlighted PEY’s high, monthly dividend payout as a key reason to buy the fund. With a yield over 4% and strong year-over-year growth, I saw this investment as a prime way to play continued low interest rates.

With that in mind, I wanted to critically examine the current dividend, to see how attractive it remains. With the sharp move higher the fund has seen this year, the yield has dropped markedly, resting more than half a percentage point below where it stood in January. While a yield above 3% is still above average, the dividend growth has also slowed, which is a key reason the yield is not higher. To illustrate, the chart below shows the recent dividend growth for the fund, along with other metrics:

Source: Invesco (with calculations made by Author)

My takeaway here is that while the dividend’s attractiveness has clearly come down, it is still a positive attribute for the fund. The yield is almost double what the S&P 500 is offering, and there has been some growth to start off the year.

With that in mind, it is important to consider the counter perspective. The fact that the yield is growing less quickly and is below 4% may mean there is limited upside from here. With the market hitting new highs, investors would surely be wise to be cautious on new investments going forward. On this backdrop, there are two primary conditions under which I would recommend PEY – a dovish interest rate policy and continued strength in the Utilities sector. While the dividend is attractive, it is not attractive enough in isolation for me to recommend this investment. Therefore, I will take each one of the two items I feel is vital to PEY in turn in the following paragraphs.

Fed Speak – Positive, For Now

As I mentioned, I am continuing to recommend dividend payers, and high-yield funds like PEY, for as long as the interest rate outlook appears dovish. Coming off 2018, dividend funds were pressured along with the market, as the Fed increased rates four times and hinted at further increases in 2019.

Despite that hawkish tone late last year, the outlook for interest rates has cooled substantially. Heading in to the May meeting we have not had any Fed rate increases year-to-date, and the Fed has actually struck a more dovish tone in recent public statements. This was the outlook I outlined in my prior review, and has so far come to fruition. Importantly, the Fed’s minutes from their March meeting continue to express a desire to keep rates on hold:

“Participants also noted significant uncertainties surrounding their economic outlooks, including those related to global economic and financial developments. In light of these uncertainties as well as continued evidence of muted inflation pressures, participants generally agreed that a patient approach to determining future adjustments to the target range for the federal funds rate remained appropriate”

Source: Federal Reserve

The takeaway here is that the Fed has changed its view quite dramatically since Q4, and the markets have reacted positively to this change. While the Fed has certainly kept the option of further hikes on the table, the market does not think it is likely to happen this year. In fact, according to data from CME Group, which tracks the futures market for investor sentiment on interest rate movements, investors actually anticipate a rate cut by year-end, as illustrated in the chart below:

Source: CME Group

Overall, this is a very dovish outlook, and is quite striking considering where we stood just a few months ago. While this outlook is fluid and can change quickly, for now high-yielding sectors remain an attractive play. With PEY holding almost half its assets in the defensive, higher-yielding Utilities and Consumer Staples sectors, the interest rate outlook should continue to be a tailwind from here. Until this reality changes, I remain convinced PEY is a relatively safe play.

Utilities Sector – Profit Surge

Earlier I mentioned I will continue to like PEY if the interest rate outlook is dovish and the Utilities sector continues to perform well. I juts discussed the interest rate piece, so now I want to focus on the Utilities sector. This is an important area for PEY because it makes up over 24% of the fund (which is down slightly from over 25% in January), as illustrated in the chart below:

Source: Invesco

Clearly, how well this sector is performing is vital to PEY, and it was an area I was optimistic on when the year started. This was driven in large part to the strong finish Utilities had in 2018, and the change in the interest rate outlook. While Utilities are no longer beating the market, the sector is still performing quite well, when looking at its year-to-date percentage gains. Furthermore, the underlying performance within the sector is also quite strong. In fact, the net profit margin for the sector as a whole is at levels not seen in decades, according to data compiled by Bloomberg, illustrated below:

Source: Bloomberg

As you can see, this helps reflect some of the strength in the sector we have seen in the short-term.

The downside here is investors could interpret this data in two different ways. On the one hand, it could be viewed as bullish, as some may speculate this trend could continue, driving shares higher still. The counter-argument would be that profitability is peaking, and the sector will not likely be able to sustain these levels for much longer, inviting an inevitable correction. While only time will tell what the next move is, I think caution is warranted regardless. I don’t think we can accurately predict “peak” earnings, so as long as the same underlying conditions remains in place (low interest rates, growing demand for energy, etc.), then I think the sector will see strong performance. However, given that the sector is seeing unusually large profits, we should not expect to see these numbers indefinitely. Therefore, I reiterate my cautious tone, but still feel upside is certainly possible.

Electricity Demand – Short Term Upside

To further explain my rationale on why Utilities could still trend higher, I want to take a look at the forecasts for electricity prices. While prices rarely move aggressively, an uptick would certainly provide a boost to the bottom-line of the companies that make up the sector. To get a sense of where we are headed, I reviewed recent forecasts from the U.S. Energy Information Administration (NYSEMKT:EIA).

A review of the April forecast provides a bit of a mixed picture. On a positive note, the EIA continues to expect annual growth in electricity prices for the next two years, as illustrated in the chart below:

Source: EIA

While these modest gains should help (if they materialize), the negative point is that these forecasts have been revised down from the January figures. Specifically, prices were expected to rise 2.7% in 2019 at the start of the year, so there has been a noticeable downward revision of a full percentage point. The forecast for 2020 has also come down, but only by half a percentage point. However, in fairness, I would not put too much stock in the 2020 forecast, as it will likely change multiple times going forward.

My takeaway here is also a bit mixed, just like the report, although there is one metric that gives me confidence in the short-term direction of the sector. I am referring to the EIA forecast that U.S. residential electricity prices will average about 2% higher than last summer. While this is not a substantial increase, it is higher than the full-year price forecast. This indicates to me that we have a better chance of seeing some momentum sooner than later, as we are heading in to the summer season now. These expected higher electricity prices should help provide a buffer in a market downtrend, providing some stability.

Bottom-line

PEY has had a nice run in 2019, and I believe the current environment continues to favor the fund. With interest rates remaining low, PEY’s high yield focus should remain in favor, as investors continue to have limited options when it comes to finding income. The Fed has shifted gears this year, and its more dovish tone will benefit dividend payers until that tone changes, which seems unlikely to happen in the short-term. Furthermore, while the Utilities sector is looking more expensive, the average net profit margin of the underling companies has hit a multi-decade high, which shows tremendous improvement over the past few years. With electricity prices heading higher over the next few months, this performance has a reasonable chance of continuing. While I would not advocate going “all in” at these levels, I believe PEY still has some upside left from here, and would recommend investors consider the fund at this time.

Disclosure: I am/we are long SPY. 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.