While this has been a difficult year for MLPs due to concerns about rising interest rates, continued volatility in the oil market and alternative energy fears, this year’s weak performance has all the trappings of a valuation extreme and a market turning point. This month’s letter will highlight why MLPs are particularly timely income investments. We introduce a new High Yield MLP Profile category to our Bespoken MLP Portfolio Profiles and explore the appeal of the Bespoken High Growth MLP Portfolio Profile.
In August Income Growth Advisors’ MLP Separately Managed Accounts (SMAs) declined 2.5%, but outperformed our AMZX MLP benchmark which declined 4.94% for the month. While our long-term performance remains impressive, it has been a challenging year for energy stocks with our year to date MLP SMAs performance off 14.6% compared to the AMZX which has declined 6.27%. Since inception, 12/31/2000, our strategy has returned 14.03% annually compared to 11.74% annually for our AMZX benchmark and 5.43% annually for the S&P 500 benchmark. Additionally, our MLP SMA strategy has outperformed against the largest MLP ETF, the AMLP, by 10.67% annually after fees.
MLP yield spreads are at elevated levels rarely seen in normal market. MLPs are yielding 5.6% over the ten-year US Treasury Note which yields 2.13%. The chart below reflects the MLP Treasury Yield spread rising to level only exceeded in the two major oil collapses of the last two decades: 2008-9 and 2014-16. Given that MLPs’ distribution growth prospects and their current attractive prices, this is an ideal time to invest in MLPs because the prospects for renewed US hydrocarbon production is excellent.
Timely Entry Point
An important attribute to successful investing is timely purchases. To quote Benjamin Graham “Buy cheap and sell dear” and “the intelligent investor is a realist who sells to optimists and buys from pessimists.” The charts below show that the relative valuation of MLPs to the S&P 500 is at exceptionally attractive levels. The only time when MLPs have been cheaper has been during crisis periods. The charts below show that relative valuations for MLPs have not been this cheap since the nadir of the 2014-16 oil bear market. The yield spread chart above show relative valuations versus the 10-year US Treasury note has not been this cheap since the 2007-09 and 2014-2016 bear markets.
Plains All American
In the second quarter, as the MLP sector continues adjusting to the new oil price environment, earnings were overwhelmingly in line with one notable disappointment, Plains All American (PAA). PAA had surprisingly weak results in its supply and logistics (S&L) segment. S&L is the business of using the company’s storage facilities to buy and hold oil at opportunistically and resell it. Similarly, the logistics segment relates to the company utilizing its broad network of pipelines to move product opportunistically from one geography to another profitably. PAA’s S&L disappointment was large enough that it cut its distribution from $0.55/unit to $0.30/unit, a mere 45% cut from one of the premiere large capitalization MLPs.
We have also seen other distribution cuts through MLP acquisitions of higher yielding MLPs by lower yielding parents. These actions are reflective of the need of large overleveraged MLPs having to right size, by cutting their distributions and paying down debt and invest in “new growth projects”. This probably explains the unusual weakness in the sector. Fortunately, as these restructuring end, the largely safe stable business models that have driven exceptional performance over the years will again be recognized by the market and those who bought from the pessimists will be enjoying high attractive growing distribution income for their intrepid sober timing.
Bespoken MLP Portfolio Profiles:
Every client has their own philosophy on how to invest. While some are happy to turn over the whole process to a capable money manager, most have a personal investment philosophy which they like to see implemented. We created bespoken MLP profiles to offer MLP portfolio profiles that can be used to construct individual portfolios or models for our clients.
We are adding a new profile this month and it is High Yield. We now offer five profiles and they are:
- Blue Chip Total Return: larger capitalization MLPs with solid distributions and growth prospects,
- Highest Quality: the safest MLPs with the lowest risk profile,
- High Growth: those MLPs with the highest distribution and cash flow growth prospects.
- Aggressive Growth: the MLPs with the highest return profiles, but whose risk profiles (balance sheet and business risks) are above average.
- High Yield: the highest yielding MLPs which do not appear at imminent risk of cutting their dividend.
This month, we are highlighting our Bespoken High Growth MLP Portfolio Profile. The following chart illustrates the financial logic for this focus. Expected returns for MLPs are generally calculated by adding the yield and the three-yield distribution growth rate. In the chart below, the expected return for MLPs with distribution growth rates over 15% is 34.3%. This number significantly exceed the historic mid teen MLP return average of the last 17 years. We believe there is a fundamental case for these high growth names that authenticates their exceptional expected returns.
Source: Barclay’s Research
The oil collapse of 2014-16 where oil declined from $107/bl to $26/bl and now is settling in the $40-50/bl range has hit some MLP and some geographies more than others. One theme we have identified is investing in those companies located in the shales with the most compelling economics. While good management can distinguish one company from another, if the cost to drill profitably is $30 in the Permian Basin compared to $55/bl in the Bakken, even if you had Elon Musk helping your Bakken team in North Dakota, profits will come much more easily for those operators in the Permian. While this illustration practically relates to exploration and production, growth in production drives pipelines and other midstream fee based business in which we invest. For natural gas, the economics are particularly attractive in the Utica and Marcellus shales and therefore companies operating primarily in that shale will have better returns than larger nationwide MLPs like Plains All American or Energy Transfer Partners.
Antero Midstream (AM) is a premier Utica Marcellus MLP and Noble Midstream is a smaller MLP with prime Permian properties. Both companies epitomize the characteristics of fast growing MLPs with historically have been tremendous performers. “Our base case forecast assumes 28% 2017-20 distribution CAGR followed by low 20% distribution growth through 2022.” Antero Midstream Morgan Stanley 8/3/2017. Barclay projections for Noble Midstream are quite impressive:
Noble Midstream (NBLX) is a new MLP backed by Noble Energy with its foot prints in the Permian and the DJ Basin making it an excellent growth MLP. Antero and Noble are both in our High Growth MLP Profile which has eight MLPs with estimated three year distribution growth averaging 22.3% and average expected returns of 26.7%.
The Value of Distribution Growth:
We created a chart for a high growth MLP which yields about 5% and projected its distribution growth rate forward at 25% for the next 5 years and then grow that distribution at 10% per year for the following 10 years. If that were to happen your Noble Midstream Partners or Antero Midstream Partners shares they could yield in the 39.58% range in 15 years. For this reason, we are emphasizing high growth increasingly in our client portfolios.
The Case for MLP Separately Managed Accounts.
Nearly 100 billion dollars are invested in MLP mutual funds and ETFs. These convenient funds pay taxes MLPs earnings and distributions causing a reduction in performance on the order of 30%. This is most vividly illustrated in the table and chart below.
The Alerian MLP ETF launched in August 2010. When comparing our MLP SMA performance against this $10.2 billion ETF, we are beating its performance by over 10% per year after fees. Wealth managers and investment advisors should consider using MLP SMAs to create attractive income streams for your clients’ portfolios.
Anyone who has over $100,000 to invest in Master Limited Partnerships should invest through separately managed accounts where the income flows through the corporation tax free and directly to the limited partner who receives income that is a return 80-90% a return of capital. Our objective is to create the largest tax advantaged income streams for our clients and MLPs offer one of the most attractive tax advantaged growing income streams one can find in the public markets.
If the reason why MLP SMAs are more attractive than MLP funds still is not clear, consider this article:
Ben Graham wrote “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” Income Growth Advisors offers investment methodologies for successful investing. Investing in MLPs combined with the unique tax advantaged structure and growing US energy market allow it to be an attractive income growth opportunity.
We offer our MLP SMA strategy through our prime brokers US Trust/Bank America/Merrill Lynch, Interactive Brokers and Folio Institutional. With recent sector weakness and normalcy returning in the oil market, now is a great time to allocate to this stable income sector. MLPs offer a clear pathway to an compelling, growing and tax advantaged income streams for retirement and investment diversification.
Last month Blue Chip MLP and Aggressive MLP profiles were the most popular. Take 10 seconds to let us know what profile is most attractive to you!