Income Growth Advisors’ MLP Separately Managed Accounts (SMAs) lost 5.03% for February. For the past twelve months, our returns rose 76.66% on a size weighted basis and after fees. Our returns significantly outperformed our benchmarks–the AMZX-MLP Index and SPY-S&P 500 Index–by 35.66% and 54.47% for the year.
Our exceptional outperformance over the past twelve months was aided by small caps American Midstream Partners, LP (AMID) and JP Energy Partners, LP (JPEP). These MLPs have announced that they will merge and have pulled back about 15% in February in advance of a special shareholder meeting on March 7th. Considering their trailing twelve month 217% and 64% respective returns, their pullbacks, considering their impending merger and portfolio diversification pressures, led to our weak February performance. We remain positive on the combined company and believe the new company (AMID) can double in the next two years as its yield drops to 5% and the company begins growing its distribution.
Our 76.66% trailing twelve-month performance was also buoyed by our market instincts. We bought through the oil decline of 2014-2016 and correctly forecasted that a rebound in MLPs would mirror the 2009 experience and we were right. We remain true believers in the earnings stability of midstream energy assets. We predicted that the exceptionally high yields generated by fundamentally sound assets would revert from the abnormally high 10-14% distribution yields to 5-7% levels as the sector recovered. These factors drove our returns.
MLPs will continue to appreciate, but not at the red-hot pace we produced last year. Their primary driver is their high yields in a historically low interest rate environment. 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) 10.46%
- JP Energy Partners, LP (JPEP) 14.3%
- Energy Transfer Equity, LP (ETE) 6.06%
- Kayne Anderson – a closed end fund we like – (KYN) 10.18%
- Teekay Offshore Partners, LP (TOO) 8.57%
The following fundamental factors and themes should drive higher midstream MLPs prices:
- MLPs have high distribution growth prospects. Their distribution growth is driven by volume growth, PPI escalators and operating efficiencies. Given historically low interest rates, the benefit of owning a security which can grow its distribution is significant. In a rising rate environment, MLPs are among the most defensive income producing investments that one can own to simultaneously produce attractive after tax income and hedge against rising interest rates and inflation.
- This phenomenon is demonstrated in the mutual fund data showing money flowing out of equity income stocks but not MLPs. This is shown on page 13 of the attached presentation. With the recent sharp rise in bond yields, MLPs have not seen the fund outflows experienced by other equity income assets. We believe that this preference for MLPs will persist due to their high yields and distribution growth prospects while investors exit fixed income alternative investments.
- The Trump administration is committed increasing US energy production and removing regulatory obstacles. We believe US energy production growth will now be in the 5-8% range annually. This will allow many MLPs to raise their distribution growth rates and add to an already attractive tax advantaged 7% yield. This yield and distribution growth profile imply annual 12-15% total returns over the next 3-5 years–a historically high investment return.
- We believe a secular low in interest rates was reached in 2016 and that long rates will rise to 6% before this reflation cycle runs its course. In July 2016, the 10-year US Treasury note hit 1.36% and ended the year at 2.45%. 10-year US Treasury rates could rise 50 basis points a year for the next 6-8 years and end the period with 10-year US Treasuries yielding around 5.45-6.45%.
- The high growth stage of the boom in shale development is behind us; however, US energy production growth is returning and should persist in the 5-8% range for several years.
- Generally, MLP outperformance will not be found in the largest MLPs whose pipelines sprawl across the entire country, but in smaller MLPs whose businesses and geographies have competitive cost advantages from their shale economics and business models.
To best capitalize on MLPs’ investment attributes, we recommend investing in SMAs and avoiding MLP mutual fund structures. MLP mutual funds and ETFs are subject to taxation of approximately 30% defeating the benefit of the unique tax free corporate structure of Master Limited Partnerships. This outperformance is illustrated below and on page 23 of our attached presentation.
Income Growth Advisor’s MLP SMAs have outperformed the AMLP exchange traded fund by 14.02% annually. (14.02% = (16.35% – 2.33%) 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.
We offer this MLP SMA strategy through our prime brokers US Trust/Bank America/Merrill Lynch, Interactive Brokers and Folio Institutional. This is a good time to allocate to this stable income sector with normalcy returning to the oil market. MLPs offer a clear pathway to an attractive, growing and tax advantaged income stream for retirement and investment diversification.
Tyson Halsey, CFA