For the past twelve months, Income Growth Advisors’ MLP Separately Managed Accounts (SMAs) rose 57.08% on a size weighted basis even though they declined 1.53% in March. For the past twelve months, our returns significantly outperformed our benchmarks: the AMZX-MLP Index by 28.76% and SPY-S&P 500 Index by 42.39%.
Market Commentary and Investment Performance:
This past quarter’s weakness in MLPs was due to declining oil prices and rising interest rates. Since the November, MLPs have been buoyed by the OPEC decision to cut oil production and the Trump administration’s pro energy policies. However, since January, concerns about compliance with OPEC’s planned production cut has led to weakness in oil prices which has hurt MLP prices. Further, both short term and long term rates have risen creating another head wind for MLPs.
Below are charts for year to date and one year periods for the Alerian MLP ETF and the XOI Oil and Gas ETF and show the price action described above.
Our benchmark outperformance over the past twelve months was driven by small capitalization MLPs including American Midstream Partners, LP (AMID) and JP Energy Partners, LP (JPEP), which merged in March. We remain positive on the recently combined company (AMID) and believe it can double in the next two years as its yield drops toward 5% and the company begins growing its distribution. Our performance was highlighted in Barron’s. http://bit.ly/Tyson_Halsey_Barrons Since the oil market has yet to come into balance and due to the severity and depth of the decline in oil, the bulk of the capital flows has been focused on “safer” larger capitalization MLPs. Consequently, we continue to see opportunities in the smaller companies where compelling shale economics or business models provide competitive advantages relative to diversified industry leaders.
Our 57.08% trailing twelve-month return was also buoyed by our market timing instincts. We bought during the oil decline of 2014-2016 and correctly forecasted that a rebound in MLPs would mirror the 2009 cycle. We remain “true believers” in yield normalization and the earnings stability of midstream energy infrastructure assets will persist. We predicted that last year’s the exceptionally high MLP yields generated by fundamentally sound assets would revert from their 10-14% distribution yields to 5-7% levels as the sector recovered. These factors drove our returns and support our continued constructive forecast for MLPs.
MLPs Offer High Yields:
MLPs yield in the 6-8% range. These high yields, in this historically low interest rate environment, will drive continued attractive returns. In a world with $8 trillion in negative interest rate debt, capital will flow to high yielding securities with stable or growing franchises like MLPs. Below are some of our largest MLP positions and their yields:
- American Midstream Partners, LP (AMID) 11.11%
- Energy Transfer Equity, LP (ETE) 5.78%
- Teekay Offshore Partners, LP (TOO) 8.68%
MLP funds offer attractive yields, but they lack the tax efficiency and distribution growth individual MLP portfolios provides. Two well-known funds and their yields are:
- Kayne Anderson MLP Investment Company – a closed end fund we like — (KYN) 10.48%
- Alerian MLP ETF (AMLP) 7.35%
Separately Managed Accounts (SMAs) versus MLP Funds:
To best capitalize on MLPs’ investment attributes, we recommend investing in separately managed accounts (SMAs) and avoiding MLP mutual fund structures. MLP mutual funds and ETFs are subject to taxation of approximately 30% defeating the unique benefit of the corporate tax free structure of Master Limited Partnerships. This outperformance is illustrated below and in our attached presentation.
Income Growth Advisor’s MLP SMAs have outperformed the AMLP exchange traded fund by 11.21% annually. (11.21% = (13.01% – 1.80%) before management fee and since inception 8/31/2010.) For the convenience of avoiding K-1s, this performance disparity is hard to justify. Consequently, for investments, more than $100,000, we recommend our separately managed account strategy.
Concentrated Stock Positions:
Another significant value added application of our MLP strategy is in helping individuals with concentrated stock positions. This past month, an executive with a $6 million stock position wanted to increase his income and diversify his concentrated position in his company stock. We designed a strategy to diversify into MLPs, by hedging part of his stock position and using the ultra-low margin borrowing rates that Interactive Brokers offers. This strategy allowed for further upside appreciation in his concentrated stock position, protect against downside risk, keep the stock’s attractive dividend, and borrow at margin rates not offered at the major Wall Street investment banks.
The critical benefits of this strategy are borrowing $2 million dollars at 1.69%, investing the loan at an 8% yield and hedging the stock. This strategy basically generates about $126,200 in incremental income for the executive, reduces his downside and preserved his upside. In this case, since his stock yields 3.14% and the margin borrowing rate on $2 million dollars was 1.69%, there was a net positive contribution “carry” from holding his stock. The total net income is closer to $189,000 annually. This example does not factor in the hedging costs and management fees, but each example will be different depending on the stock and the client’s objectives. This example generates about $160,000 in incremental income annually, reduces single stock risk and defers capital gains until later years.
My experience in the Corporate Executive Service Group (CESG) at Alex Brown and option trading experience on the 1980s on the New York Futures Exchange makes us well suited for customized hedging strategies. In combination with our MLP management experience and Interactive Brokers industry leading margin rates, we can provide industry leading value added solutions. Consequently, we welcome opportunities to do a basic strategy analysis for anyone with a concentrated stock position. And if Nobel Laureate Robert Shiller is correct and equity market values are near historically high levels, a hedging and diversification review would be a thoughtful and timely exercise.
Separately Managed Accounts:
For basic income and total return minded investors, we offer our MLP SMA strategy through our prime brokers US Trust/Bank America/Merrill Lynch, Interactive Brokers and Folio Institutional. Given the still improving energy market, this is a good time to allocate to this income sector. MLPs offer a clear pathway to an attractive, growing and tax advantaged income stream for retirement and investment diversification.
If you have any interest in discussing specifics regarding the strategies outlined in this letter, please feel free to contact us.
Tyson Halsey, CFA