Income Growth Advisors, LLC MLP Separately Managed Account (SMA)’s rose 4.40% in January. For the trailing twelve months, we delivered strong performance with returns up 79.05% 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 39.46% and 61.60% for the year.
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 were and are believers in the earnings stability of midstream energy assets and the benefits of the corporate tax free status of MLPs. We felt that the exceptionally high yields from fundamentally sound assets would revert from the abnormally high 10-14% distribution yield ranges to 5-7% as the sector recovered. We wrote and maintain that this was and is a classic boom-bust cycle of overbuilding and excessive optimism which turned to utter panic and depressed prices. We felt that over time stability would return to the sector and with it a healthy rebound which our returns now reflect. We also focused on special situations where smaller companies enjoyed unique attributes not universally shared by all MLPs. These factors drove our returns.
MLPs will continue to appreciate, but not at the red-hot pace we produced last year. Our macro-economic analysis should continue to drive solid returns and outperformance. Below are some of the key fundamental factors and themes we expect will impact MLPs:
- The Trump Presidency is an important positive for energy production growth in the United States. We believe US production growth will be 2-3% higher over the next 3-5 years than if he weren’t elected. US energy production growth would have been in the 3-5% range, but now we estimate to be in the 5-8% range. This will allow many MLPs to raise their distribution growth rates by adding to an already attractive tax advantaged 7% yield. These assumptions imply 12-15% total returns for MLPs over the next 3-5 years–a historically high investment return.
- A secular low in interest rates may have also been reached in 2016. We believe that long rates will rise to 6% before this reflation cycle of 8 years runs its course. In July, the 10-year US Treasury note hit 1.36% and ended the year at 2.45%. Rates could rise 50 basis points a year for the next 6-8 years and the 10-year US Treasury note could end the period with 10-year US Treasuries yielding 5.45-6.45%. This yield level would be normal and healthy. It would make retirement asset management easier to achieve its actuarial goals. Rising rates would have the positive benefit of removing the bubble underpinnings of the great monetary stimulation of the last eight years. Rising rates historically hurt yield investments, but this should be a manageable countervailing force.
- The major boom in shale is behind us; however, US energy production growth should return and persist in the 5-8% range for several years.
- Outperformance will not be found in the largest MLPs whose pipelines sprawl across the entire country, but in those MLPs whose businesses and geographies give them a competitive cost advantages based on their shale economics and business models.
- The key unique attribute that MLPs have is their high distribution growth. That distribution growth is driven by volume growth, PPI escalators, and operating efficiencies. Following zero inflation and historically low rates, the benefit of owning a security which can grow its distribution at a rate greater than the inflation rate is significant. In a rising rate environment, MLPs are among the most defensive income producing investment that you can own to simultaneously produce attractive after tax income and hedge against rising interest rates and inflation. That perception is exemplified in the mutual fund flow data showing money flowing out of equity income stocks but not MLPs at year end 2016 and shown on page 14 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 as the energy and MLP market strengthens and investors exit fixed income alternative investments.
To best capitalize on MLPs unique investment attributes, we recommend investing in separately managed accounts and avoiding MLP mutual fund structures. MLP mutual funds are subject to taxation of approximately 30% defeating the benefit of the tax free corporate structure of the Master Limited Partnership. This outperformance is illustrated on Page 24 of our attached presentation and below.
IGA’s MLP separately managed accounts have outperformed the AMLP Exchange Traded Fund by 14.89% annually. 14.89% = (17.5% – 2.6%) before management fee and since inception 8/31/2010. For the convenience of avoiding K-1s, this performance disparity is tremendous. Consequently, for investments, more than $100,000, we recommend our separately managed account strategy.
We offer this strategy through our prime brokers US Trust/Bank America/Merrill Lynch, Interactive Brokers and Folio Institutional. We believe this is a particularly sensible time to evaluate your allocation to this attractive sector – the yield spreads over other income vehicles are still wide and normalcy is returning to the oil market. We see a clear path to generating solid performance and creating an attractive growing tax advantaged income stream for retirement and investment diversification.
Tyson Halsey, CFA