Publicly traded master limited partnerships (MLP) have had a rough run since last July despite generally strong fundamental performances. If history is any guide, this marks an outstanding buying opportunity for the group.
For those unfamiliar with these securities, MLPs aren’t corporations but partnerships that trade on the major exchanges just like any other stock. You can purchase MLPs through your broker and will pay normal commissions just as if you were buying IBM or GE; more than three-quarters, in fact, trade on the New York Stock Exchange (NYSE).
However, there are some key differences between MLPs and corporations. Chief among those are that MLPs pay no corporate-level taxation. Instead, these companies pass through the majority of their income to unitholders--MLP parlance for shareholders--as regular quarterly distributions.
These distributions aren't taxed as dividends but are extremely tax-advantaged. In most cases, MLP holders won’t have to pay tax on 70 to 90 percent of the distributions received until they sell their units. This allows significant tax deferral advantages.
Most US-traded MLPs focus on the energy business. The vast majority are involved in what are called midstream operations. This generally means owning energy infrastructure assets such as pipelines, oil and gas storage facilities and natural gas processing plants. Some MLPs have branched out into other energy-related businesses, such as owning tankers, leasing capacity on production platforms and even actually producing oil and natural gas.
The common thread linking most of these infrastructure businesses is that they’re extraordinarily steady and cash generative. For example, companies that own pipelines aren’t paid based on the value of oil or gas traveling through their pipes; instead, pipeline operators receive a fee linked to the volume of gas transported. In many cases, fees are partly or fully guaranteed under long-term contracts. In other words, once a pipeline is built, the owner can expect to receive regular, reliable cash fees with limited need for ongoing maintenance spending.
Because partnerships pay no corporate level tax, most of that cash finds its way into unitholders’ pockets. The average partnership in the industry benchmark Alerian MLP Index pays a yield of more than 7 percent; some pay yields of 13 percent or more. Even better, MLPs have a long history of increasing their distributions over time. In short, MLPs offer high, growing income.
Despite these defensive, recession-proof characteristics, MLPs aren’t always immune to market turmoil. The Alerian MLP Index pulled back by roughly 23.5 percent from its July 2007 highs to its March 2008 lows. (See the chart below.) This pullback, however, doesn’t appear to be grounded in fundamental reasons.
Typically, income-oriented stocks perform poorly when they cut their dividend distributions. Because most investors hold such stocks to get their regular dividend checks, investors have a tendency to run for the exits as soon as that income appears to be in jeopardy.
So, if you just look at the chart of the Alerian Index above, you might assume that the partnerships are having trouble sustaining their payouts. But nothing could be further from the truth; in fact, the vast majority have actually been raising their distributions over the past few quarters.
I studied all 50 publicly traded partnerships (PTP) in the Alerian Index over the past 12 months. Out of this universe, only one partnership, Calumet Specialty Products (NSDQ: CLMT), has cut its distribution over the past year. Just less than 84 percent of these partnerships have actually raised their distributions over the past six months. On average, the MLPs in this index have actually boosted their distributions by 13.7 percent year-over-year. Rising payouts is hardly the sign of an industry in trouble.
There are some valid reasons for the pullback in the Alerian Index. For example, some partnerships relied on public investment in private equity (PIPE) deals to finance transactions last year. In a PIPE deal, the MLP sells a block of shares to an institutional player at a discounted price. For smaller MLPs, it can be difficult to sell shares directly to the public in a secondary offering; PIPE deals may be the only way to raise cash quickly.
PIPEs aren’t immediately listed for trading. Instead, institutional buyers are typically locked into such deals for a few months. This all works beautifully as long as the market for MLP stocks is rising; institutional players are quite happy to buy shares at a discounted price and earn a few extra percent on their cash.
But last year the deteriorating credit conditions and severe market selloff left many hedge funds scrambling to raise cash. Many sold out of their PIPE shares as soon as those shares were listed for trading. In some partnerships, this meant a flood of sell orders motivated solely by a pressing need to raise cash.
Another factor pressuring the MLPs was new initial public offerings (IPO). In the strong market for MLP shares of late 2006 and early 2007, many new partnerships decided to list their units. The problem: The MLP universe is still relatively small. Some traders have a tendency to sell out of existing holdings to purchase the new IPOs as they come public. This added supply of new MLPs can also pressure the broader Alerian Index as investors rebalance their holdings.
Finally, there are some legitimate concerns about credit conditions. After all, many MLPs finance their operations using debt and credit became harder to come by after last July. Some feared that the MLPs would find it expensive to take on debt. Although that’s true in some cases, most MLPs continue to have ready access to capital and credit; thanks to their steady, recession-resistant cash flows, most MLPs represent attractive credit risks.
Nonetheless, a pullback still hurts whether it makes sense fundamentally or not. Rising distributions may soften the blow, but they hardly have made up for the 23 percent-plus pullback in the Alerian Index. Many investors have undoubtedly been scared off by this weak showing.
However, it’s important to recognize that this action is really nothing new for the MLPs. Over the past 12 years, the Alerian MLP Index has seen a total of five pullbacks of 10 percent or greater; you can see these on the chart above. The average correction from intraday high to intraday low is 21.2 percent; the steepest correction to date was just under 30 percent back in 1998-99.The current pullback is roughly average so far at 23.5 percent.
More important, look at the performance of the Alerian Index after each of these corrections. On average, the index returned nearly 35 percent in the first year following the correction. In other words, pullbacks of 15 to 25 percent have typically marked outstanding opportunities for investors to jump into MLPs offering attractive, sustainable yields.
Bottom line: Corrections are painful, and the selloff in MLPs lately has been no exception. However, select MLPs still offer large yields and steady, noncyclical growth opportunities. The recent pullback appears to have ended in March; certainly, the correction since last July is roughly average with historical norms. The precedents are good for a big move higher over the next six to 12 months.
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