MLPs – An Early Christmas Present by Evergreen Gavekal
“It is madness to risk losing what you need in pursuing what you simply desire.” – Warren Buffett
EVERGREEN VIRTUAL ADVISOR
- Almost all investors today are in need of better valuations to support their long-term return prospects and/or better cash flow to fund their ongoing spending needs.
- The problem is that almost everything has been overvalued for the past several years. This “purgatory of low returns” left investors with a limited list of uncomfortable options: (1) reach for ever-shrinking yield, (2) chase capital gains in overvalued markets, or (3) sit in cash.
- But with credit spreads blowing out and oil prices collapsing over the past year, the markets are giving us an early Christmas present: deeply discounted midstream Master Limited Partnerships (MLPs).
- MLPs have not necessarily bottomed, but we believe they will benefit from a faster-than-expected recovery in the energy markets over the course of the next few years. And with yields currently in the high single-digits, we believe investors are being well compensated to look through the cycle and wait patiently for a recovery.
- By making it more palatable to hold large cash reserves and to stay defensive across our client portfolios, the combined value and yield opportunity in high quality midstream MLPs is helping us to (1) create enough cash flow for our clients to live on while (2) protecting their portfolios against the upcoming bear market in US equities.
- The markets have seen fit to let us unwrap one present, but we still have to wait patiently through the night for “Christmas morning” when investors can rotate back into stocks at fire sale prices.
AN EARLY CHRISTMAS PRESENT
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By Worth Wray, Chief Economist
Does your family have any Christmas traditions? Mine certainly does.
On Christmas Eves growing up in South Louisiana, my family would always come home from church late in the afternoon, cook a holiday feast together, and gather around the fire to read the Cajun Night Before Christmas. (Yes, where I come from, Saint Nick rides a skiff pulled by eight flying alligators.)
Then and only then, my three siblings and I each got to unwrap one present before bedtime… although the decision was not always up to us. Some years, my parents would let us choose any package wrapped under the tree. Other years, they would have a specific one in mind.
As you can imagine, opening just one was often agonizing for a child who had not yet learned the value of delayed gratification and had been staring at a tree full of gifts for weeks on end. By the time Christmas Eve rolled around, I usually felt like I had been patient long enough and so those last 8 hours between bedtime and Christmas morning were the hardest.
I can remember laying awake at 3:00 AM on more than one occasion, torn between the greed of sneaking a peek at what Santa had delivered and the fear of losing what could be mine if I could just wait a few hours longer. For a little boy who believed in Christmas magic longer than most of my peers, I didn’t want to be the kid who makes it onto Santa’s naughty list at the last minute and then wakes up to find a stocking full of coal.
And so I waited – sometimes all night – for morning to come… for presents, and stockings, and hot chocolate by the fire… for Cajun eggs benedict and hours of laughter… for enough magic to last through the year. Those mornings were always worth the wait.
Now that I am married and in my thirties with bills, responsibilities, and a life of my own, I could not be more grateful for Christmas mornings on the bayou.
Oddly enough, the whole experience prepared me for the emotional roller coaster of investing by teaching me to accept what the market gives me, helping me to learn the rewards of patience, and forcing me to weigh the potential cost of impatience.
Those are important lessons for investors today, especially considering the drama we’ve all lived through in recent years. In a world of ultra-low interest rates and almost universally overvalued markets, value became almost impossible to find after markets recovered their losses from the global financial crisis. In July 2013, GMO’s James Montier described this period as “the cruelest time to be an asset allocator” arguing that everything had become expensive from equities and credit to commodities and US Treasuries.
What’s more, yield was nowhere to be found. The universe of fixed income assets yielding over 4% shrunk by more than 75% after the Fed dropped interest rates to zero in 2008 (figure 1). The whole concept of relying on livable cash flows from low-volatility investments like US Treasuries, munis, and investment grade bonds went out the window just as the Baby Boomers (the generation born between 1943 and 1960) started to reach retirement age (figure 2).
As recently as early 2014, this “purgatory of low returns” left investors with a limited list of uncomfortable options:
(1) We could reach for ever-shrinking yield to fund our spending needs, which meant taking on substantially more risk in less familiar and often less liquid asset classes like junk bonds, Master Limited Partnerships (MLPs), or emerging market debt.
(2) We could chase capital gains in overvalued asset classes like US stocks, feeling wealthier while effectively locking-in disappointing long-term returns and/or setting ourselves up to make emotional mistakes in a correction.
(3) Or we could sit in cash, avoiding market losses while steadily losing purchasing power to inflation and personal spending. While this is clearly the most prudent option in the face of overvalued, overextended markets, sticking to a value discipline in the face of rising markets can take a heavy psychological toll as the market screams higher.
Fortunately, times are changing.
With credit spreads* blowing out (figure 3, next page) and oil prices collapsing (figure 4, gray line) over the past year, the markets are giving yield-starved retirees, cash-heavy contrarians, and reformed performance-chasers an early Christmas present: deeply discounted Master Limited Partnerships (figure 4, green line).
*The difference between corporate bond yields and US Treasuries of comparable maturities
Let me be clear, I’m not saying the MLP asset class has necessarily reached its bottom; but it’s a whole lot closer than the richly-valued S&P 500, which continues to trade near all-time highs (figure 4, white line) despite falling profit margins (figure 5) and a higher median price/sales ratio than the market peaks in both 2000 and 2007 (figure 6).
As you can see in the chart on the next page, the Alerian MLP Index has fallen roughly in line with the 2007-2008 crash and continues to trade at extremely depressed levels as a result of falling energy prices and rising high yield spreads.
FIGURE 7: ALERIAN MLP INDEX, TODAY VERSUS THE GLOBAL FINANCIAL CRISIS
Source: Evergreen GaveKal, Bloomberg
The thing is, we still haven’t seen a single distribution cut in the midstream/pipeline space (excluding Kinder Morgan, which is no longer an MLP). MLP prices have cratered with oil, but the underlying fundamentals in a number of blue chip midstream partnerships have not meaningfully changed.
In light of last week’s OPEC breakdown, next week’s Fed hike, and the continued slide of China’s yuan, there are plenty of reasons to think oil prices – and thus MLPs – could fall further on short-term oversupply and/or the rising risk of a global recession.
Then again, we could just as easily see prices rebound next year as production cuts and well depletion in places like the United States, Mexico, and the North Sea bring global supply back in line with global demand faster than the markets currently expect.
No one knows where the oil price is going over the short-term, but, regardless of whether prices bottom in the low $30s (like most of the Evergreen investment committee believes) or $20 (as I’ve been saying for the past year), it is virtually inevitable that we will see higher oil prices in the next three to five years as a function of production cuts, supply disruption, and/or an eventual reversal in the US dollar. In fact, if I am right and crude oil falls all the way to $20 per barrel, that kind of collapse should set the stage for an even more spectacular price recovery as massive amounts of production come offline.
Yes, there will be volatility. Yes, your portfolio values will likely fluctuate. In a market now dominated by computerized trading and exchange traded funds (ETFs), we have to expect good assets to be thrown out with the bad in times of stress.
But therein lies the opportunity.
Should prices decline even further, we can buy more. Should one of the major MLPs send a shockwave through the industry by cutting their distributions/dividends, we can take advantage of that by buying up quality assets at even deeper discounts (as we did at the depths of the global financial crisis in December 2008).
Who doesn’t love a fire sale when you have cash on hand? From that perspective, the combined yield and value opportunities in midstream MLPs with high coverage ratios (cash cushions for paying ongoing distributions) may be one of the best three to five year total return opportunities we’ve seen since March 2009.
With annual distribution yields already in the 9% range, you’re getting paid handsomely to look through the cycle and wait patiently for a price recovery… volatility be damned.
FIGURE 8: MLP YIELDS VERSUS CASH FLOW ALTERNATIVES
Source: Evergreen GaveKal, Alerian
Yes, it may be emotionally difficult to set your account statement aside and accept the higher risk that comes with higher yields. But that’s why MLPs offer so much more cash flow than other assets today.
Most investors who bought into MLPs over the past several years were reaching for yield through mutual funds or ETFs. They weren’t buying individual securities. They didn’t understand the asset class. In many cases, neither did their financial advisors who, as recently as 2014, sold them on the promise of attractive yield (when yields were closer to 3%) and steady growth (just as my colleagues at Evergreen were writing that MLP prices were due for a correction).
It’s natural for the average investor to run for the hills when oil prices collapse, high yield spreads widen, and the financial news media write uber-bearish articles based on the uninformed opinions of bucket-shop hacks.
It’s easy to get caught up in the moment, but there is no substitution for doing your homework… or searching out an experienced investment team with a discernable edge.
Like I said, almost all investors today are in need of better valuations to improve their long-term return prospects and/or better cash flow to fund their ongoing spending needs.
Now we finally have a more workable set of choices:
(1) We can embrace beaten-up assets like MLPs to significantly boost our overall portfolio yields and improve our long-term return prospects.
(2) We can chase capital gains in overvalued asset classes – like US equities.
(3) Or we can sit in cash.
At Evergreen GaveKal, we believe in a mix of door #1 (beaten-up assets, particularly high quality energy stocks, Canadian REITs, and MLPs) and door #3 (large cash reserves) within the context of a sufficiently diversified portfolio. As a firm, our principal goals at this stage in the stock market cycle are to (1) create enough cash flow for our clients to live on while (2) protecting their portfolios against an equity bear market. We aren’t bunker investors or permabears – as our investment committee’s decision to start buying equities in December 2008 will attest – but with stocks currently trading at such lofty valuations, we believe it’s prudent to be defensive. Like I’ve written in past EVAs, this isn’t just about minimizing short-term portfolio losses, it’s about maximizing your portfolio’s long-term potential.
The problem is, a lot of our clients need income as we patiently wait for a more broad-based correction in the equity market. And that’s where midstream MLPs come in today.
After reducing our firm-wide MLP allocations to their lowest levels in a decade going into the summer of 2014, our investment committee has been steadily adding to high quality names as prices have declined. Many of those purchases show up on account statements as losses, but we’re confident that they will provide solid returns over the next few years. And in the meantime, we believe our clients are being well compensated to sit back and be patient.
There is simply no way to have an income mandate in this environment and expect to have a low risk portfolio, but higher yields can make large cash holdings more bearable. And large cash holdings can dampen the volatility of higher-yielding assets.
The markets have seen fit to let us unwrap one present (beaten-up midstream MLPs), but we still have to wait patiently through the night for the big opportunity (a major equity correction).
Like a child who sneaks out of bed in the middle of the night to scope out his or her toys a few hours early, staying overweight equities in this environment may seem like a good idea as long as prices continue to climb. But you’re running the risk of waking up on Christmas morning with nothing but a lump of coal… and significant losses on your account statement.
If, instead, we leave our milk and cookies by the fire, gratefully accept our portfolio-enhancing present, and patiently wait for Christmas morning, the market will eventually give us the opportunity to rotate back into more aggressive portfolios for the next bull market.
Merry Christmas to all and to all a good night!
WORTH WRAY / Chief Economist
To contact Worth, email:
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