A funny thing has happened on the way out of the Great Recession.
Investors may still see capital appreciation as a big priority, but the days of adopting the old “65-35” rule are in decline.
In Wall Street parlance, 65-35 is the ratio of stocks to bonds in your portfolio when you’re 35 years old. As that 35-year-old rolls toward retirement, the scenario flips, and by age 65, the ratio of stocks to bonds is inverted, with 35% of the portfolio composed of stocks and 65% of bonds.
Of course, this is not a hard and fast rule. It’s just a rule of thumb from cautious money managers and financial advisors who wanted two blueprints for two very different investors:
• Younger investors, having more time to recoup losses, could absorb more risk, and hence could have bigger positions in stocks.
• Older investors, with less time to recover from stock market shocks, should have stronger positions in capital preservation investments, like bonds.
But as the economic malaise commenced in 2008, and as investors viewed the stock market as unusually risky (though the S&P 500 has remained steadfastly in positive territory during the past four years, even with the downturn), terms like “safe haven” and “flight to safety” have dominated advisor/investor discussions.
For energy investors, that conversation has increasingly been steered toward a new investment, but one with a higher performance upside than bonds – income-producing master limited partnerships (MLPs).
By and large, MLPs are a hybrid investment vehicle – part bond and part stock. On the equity side, MLPs have historically strong current income yields and burgeoning dividends. Portfolio returns have been strong, as MLPs have outperformed the S&P 500 in 11 of 12 years.
On the fixed-income side of the issue, MLPs offer some downside protection against falling equities, especially commodities, thus giving investors some good, solid risk reduction protection.
Greg Reid, managing director of Salient Partner, which runs the Salient Master Limited Partnership, says energy MLPs are a big “growth” investment.
In a recent podcast interview with MoneyShow.com, Reid says the MLP story is all about yield.
“What makes MLPs very attractive, I think, for all types of investors, is they do pay out most of their cash flow in the form of distributions, essentially their dividends,” he says. “The current yield is approximately 6.25% in the industry now.”
“What's really interesting is most of that income is tax-deferred return of capital. So the after-tax return is very high,” he adds. “And these companies are growth companies, meaning they grow their cash distributions on average about 6% to 7% per year. So investors have gravitated toward this space because they've enjoyed returns over the last decade that have been about 16% a year.”
Others agree, but add that investors have to be especially vigilant about energy MLPs.
In comments to Oil and Gas Investor, Michael Peterson, managing director of energy research at MLV & Co., cites three specific strategies investors should embrace when evaluating energy MLPs:
• Seek over/under pricing of risk.
• Look for medium-term sustainability.
• Look for long-term growth.
Above all, Peterson advises energy investors to “embrace MLPs as a long-term investment vehicle” and to “avoid thinking of MLPs as trading vehicles … for the sake of your tax accountant.”
“The key criteria in evaluating yield-focused investment vehicles, like MLPs, is the relationship between return and risk, Peterson says.
He calls for investing into six broadly divided sub-sectors with corresponding current yields ranging from 5.6% to 8.7%. Within those categories the two highest yielding sub-sectors (coal and upstream producers) have direct revenue exposure to the price of energy commodities, while the remaining sub-sectors are indirectly exposed to energy commodities. Direct commodity exposure, due to the underlying volatility of prices, presents greater risk and therefore mandates higher corresponding returns, he says.
“The best strategy for investors is to determine whether the incremental yield of a specific investment is sustainable and adequately reflects the underlying incremental risk on a long-term basis; buying when the yield exceeds that mandated by the underlying risk and stepping away when the yield is insufficient,” Peterson adds.
Darren Schuringa, managing partner at Yorkville Capital (Yorkville’s sister company, Yorkville ETF Advisors, runs the Yorkville High Income MLP ETF) seconds that motion, adding that his fund looks for three key criteria before investing.
“As a general rule of thumb, we like to look at MLPs that offer sizeable yields, potential for distribution growth and potential for capital appreciation,” he says. “In order to find these opportunities, we focus on current yield, distributable cash flow and distribution growth (both historical and forward looking.)
“When it comes to sector focus, we find it is best to look at both the infrastructure and commodity segments of the MLP asset class,” Schuringa adds. “Depending on one’s risk profile and goals, either a commodity MLP focus or infrastructure MLP focus can be appropriate. In this sense, it is important to differentiate among different types of MLPs. Infrastructure MLPs, including oil and gas pipelines, enjoy more popular recognition and generally are considered to be stable, toll road businesses. Commodity MLPs, meanwhile, include various sectors such as marine transportation and exploration and production and offer higher yields along with similar potential for distribution growth.”
A good example is Linn Energy LLC, he adds. Linn, an exploration and production MLP, is currently the 11th largest energy producer in the U.S. and is expected to double production by 2016. “We especially like LINE because it is hedged 100% on oil production through 2017 and 100% of gas through 2015. This means that short-term movements in energy prices should have only a minimal impact on future distributions or the share price. Linn, which yields more than 7%, has also made several acquisitions in the past few months. That should prove accretive to future profits, including their purchase of the Jonah Field Properties in Wyoming from BP.”
Schuringa also likes Atlas Energy LP (ATLS), the general partner of both Atlas Resource Partners and Atlas Pipeline Partners. “We see ATLS as a leveraged way to the two partnerships, providing access to two MLP sectors (gathering and processing; exploration and production) in a single investment,” he notes. “While ARP is poised to grow from recent gas reserve purchases, APL looks to benefit from continued volume growth at its major plants in addition to future capital projects. As a result, ATLS unit holders will be the direct beneficiaries. We anticipate that ATLS (which currently yields around 3%) will continue to grow its distributions at a high rate, sending the stock price even higher.”
If investors can commit to a “buy and hold” strategy with energy MLP’s, they just might find a new safe haven investment that does fixed-income investments one better: It adds an income upside to a relatively low-risk investment.
Current MLP Yields By Sub-sector
|Source: MLV & Co.|