Searching for Good Odds

Last week I was in Las Vegas for 48 hours attending a conference. Dear reader, before you smile at this lame attempt to disguise play as work, you should know that I don’t gamble, drink only moderately and do not enjoy loud rock music. Therefore, the sight of yours truly staying at the Hard Rock Hotel and Casino might strike you as incongruous to say the least; I can report that the thumping rock music is as inescapable as the screens of Big Brother in George Orwell’s book 1984. Elevators and bathrooms offered no escape.  Fortunately, I was with many friends from Catalyst Funds, our mutual fund partner, and their company made it a thoroughly worthwhile and enjoyable visit. However, as my wife noted, if you’re planning a weekend of alcohol-infused debauchery and gambling, I might not be your best choice of travel companion.Casino Image 3

Las Vegas stands for many things; as I walked through the hotel casino full of hopeful slot machine fanatics and blackjack buffs it reminded me that the entire city stands as a testament to a glaring failure of classical economics. In the theoretical world where individuals make rational decisions to maximize their utility, Nevada’s gaming tables with their negative expected outcomes should have no place. The cheerful acknowledgment of punters that the odds favor the house further illustrates how poor are the economist’s tools for explaining the world. One can only square the circle by allowing that the irrational hope of winning big provides positive utility to those relieved of their cash. State-run lotteries work on the same principle, and we non-lottery buyers theoretically pay slightly lower taxes as a result (although that’s hard to believe in New Jersey). The surest way to win is to be a free-rider; the Hard Rock Hotel’s $43 nightly room charge dramatically underprices the facility, because they rely on guests contributing substantially more in the casino. As a stalwart non-participant, I thank my fellow guests for subsidizing my stay. Meanwhile, consider the tormented soul whose $150 “safe” bet on Michigan State to beat Middle Tennessee in the NCAA tournament was lost but would in any case have only paid out $2.15. Let’s at least hope he derived some modest pleasure from temporarily anticipating his winnings. This is someone with a gambling problem.

There have been moments as an MLP investor in recent months when selling out and placing everything on black might have felt more rational and maybe even offered better results. The constant search for good odds in financial markets renders casinos uninteresting, even while MLPs for a while seemed like a faster way to lose money. Fund flows have certainly been an important driver of near term performance, as noted in last week’s post (Up Is The New Black). Figures on MLP fund flows provided recently by JPMorgan were striking, showing that in February $570MM of net inflows came into the sector. This is a substantial show of confidence by retail investors; it more than offset the net outflows ($543MM) that occurred during the entire second half of 2015, during which MLPs sank by 24%. The -0.5% February loss in the Alerian Index masks the substantial intra-month collapse and rebound that the $570MM of inflows helped fuel.

The appetite of retail investors to buy, and then sell, and now buy again MLPs has been a significant factor driving performance. As noted in The 2015 MLP Crash; Why and What’s Next, for a time such investors bridged the gap between MLPs’ need for growth finance and the limited desire of traditional investors to meet it. Direct investors in MLPs who receive K-1s are the quintessential long term investor, not least because time steadily worsens the tax consequences of selling. Retail investors through mutual funds and ETFs are not always so tax-sensitive, and therefore more reactive to recent performance. February’s substantial inflows reflect this shift to more positive sentiment.

Up Is The New Black

Watching the Valeant (VRX) disaster unfold has, for those who are bystanders like us, resembled viewing an express train hurtling off an unfinished bridge into the ravine below, taking with it the reputations of some highly regarded investors. You’ll find no criticism here – professional humility has always been part of our DNA but if it wasn’t, enduring the 58.2% collapse in Master Limited Partnerships (MLPs) from August 31st, 2014 to February 11th, 2016 assured an additional helping (those dates and figures are imprinted in my memory). Watching someone else’s catastrophe is an awe-inspiring distraction, in the same way that one feels sorrow for the victims of a foreign earthquake while assuring oneself of the sensible choice to not live on a fault-line. We’ll resist the self-satisfied observation that Valeant’s fall eclipsed even the most hated energy infrastructure MLP. During a stunningly brief period of a few months from August 5th, 2015 through last Friday, down for VRX investors was a long way – a staggering 89.7%.

We have no opinion on VRX and certainly wouldn’t suggest that its collapse was obvious. But it’s often the case that fund flows develop their own momentum. While Pershing Square and ValueAct, two large hedge fund investors in VRX, can manage their exposure to this calamity with little regard to fund withdrawals given their long lock-ups, the asset base of Sequoia’s mutual fund (SEQUX) is at the daily whim of its investors. Having similarly peaked with VRX on August 5th, SEQUX is down 33.5% and redemptions are likely causing unwilling selling of VRX by its managers. Morningstar’s placing of its rating under review can’t have helped their fund marketers.

MLP Sources and Use for Jan 3 2016 BlogWhatever the true value of VRX, in the short term Ben Graham said the market’s a voting machine, and investing in public equities forces you to endure the popularity (or loss thereof) of your holdings. MLPs certainly found that even as their security prices offered ever greater discounts to value, the marginal investor was nonetheless more often a seller rather than a buyer.

It’s worth revisiting the above chart, originally shown in early January (see The 2015 MLP Crash; Why and What’s Next), which remains our best explanation for the substantial dislocation we endured. Although MLP distributions (in red) used to comfortably exceed new capital raised (in blue), the Shale Revolution gradually reversed this relationship by creating an ongoing need for new infrastructure which required financing. The increasing shortfall between cash paid to investors via distributions and cash taken back via IPOs and secondaries was, for a time, met with new money from mutual funds and ETFs (in green) until falling prices induced these more recent investors to curtail inflows and eventually switch to outflows. Ultimately, institutional flows from non-traditional MLP investors were attracted (see Real Money Moves Into Real Assets). Although operating performance of midstream MLPs wasn’t immune to the collapse in oil, their stock prices often fell by  many multiples of their drop in EBITDA. We continue to believe that what happened exposed the financing model of MLPs far more than their operating results, and that the flow of funds explanation is the most likely cause.

One pre-requisite for buyers to overwhelm sellers is excessive pessimism, and VRX is at least approaching that zip code. 21 of 23 analysts following the stock were bullish prior to last Tuesday’s earnings call, following which there was an undignified rush for the relative anonymity of a target price close to the current market. One firm slashed its target price from $200 to $70 (on Friday VRX closed at under $27). MLPs saw something similar over the past several weeks (see Pity the Equity Analyst) as sell-side analysts reacted as humans to the relentless criticism their bullish forecasts received from investors apportioning blame for their losses. On recent trends, MLPs should soon be positive for the year. The last time that could be said was May 8, 2015. Over the following seven and a half months the sector turned in its worst year ever. Whether or not February 11th, 58.2% below the August 2014 high, was the low for MLPs, it couldn’t be so without sufficient Wall Street analysts giving up. Industry mutual fund flows were heavily negative into the end of 2015, and there’s evidence more recently that flows are turning.  We’re still 43% below the market peak. It is at least no longer unfashionable to expect rising MLP prices.

On Thursday, TransCanada (TRP) announced that they had agreed to acquire Columbia Pipeline Group (CPGX) for $10.2BN in cash (of which $4BN was funded with the proceeds of a TRP secondary offering of equity). The Wall Street Journal had reported on the negotiations several days earlier. TRP of course is behind the Keystone XL pipeline project which was eventually blocked by the Administration, further challenging Canada’s E&P companies as they seek ways to ship crude oil from Alberta to foreign markets.

CPGX is the General Partner that controls 15,000 miles of natural gas pipelines, mostly at the GP level although their MLP Columbia Pipeline Partners (CPPL) holds some of the assets. TRP saw no need to acquire CPPL, since their acquisition of CPGX already gives them control of CPPL and thereby retains the ability to continue dropdowns into the MLP where assets can be more cheaply financed although crucially this financing option isn’t currently available. The deal is the classic use of the MLP/GP structure. CPGX as the GP is analogous to a hedge fund manager, and CPPL is the hedge fund. Owning CPGX provides control of CPPL. CPGX, or now TRP, can eventually move assets into CPPL and continue to earn Incentive Distribution Rights on them, similar to a hedge fund manager earning a fee on assets in his hedge fund.

March 20 Blog GPGX Chart

Although the acquisition valued CPGX at 19X 2016 estimated EV/EBITDA compared with TRP’s 12.75X, TRP expects the transaction to be accretive from 2017 as some of the CPPL backlog drops into production. TRP expects to finance $8BN of projects at CPGX over the next four years, earning $5.5BN in EBITDA over that time and exiting 2020 at a $1.7BN run-rate. The cancellation of Keystone and delay in another big project (Energy East) has left room in TRP’s budget, in addition to which TRP’s size leaves it better placed to finance this kind of backlog. Prior to the deal, CPGX was yielding 2.25%. Moreover, CPGX and CPPL moved sharply in opposite directions following the announcement (Chart Source: Yahoo Finance), as the market reflected the control premium paid for CPGX that wasn’t necessary for CPPL. This illustrates why owning MLP GPs is better than owning MLPs.

We were invested in CPGX until Friday and remain invested in TRP

Wall-Street-Potholes-CoverLack_Wall Street Potholes

 

 

 

On Wednesday,,March 23rd at 7pm, I’ll be giving a presentation on my new book, Wall Street Potholes,  at the Westfield Memorial Library, Westfield, NJ. Attendance is free.

Are You in the Wrong MLP Fund?

For those who follow MLPs closely, one of the enduring mysteries must be the mindset of investors in the Alerian MLP ETF (AMLP). Investors who desire MLP exposure but don’t want K-1s have been attracted to AMLP and a whole host of other inefficient ETFs and mutual funds. As we’ve written before (see, for example, The Enormous Misunderstanding About MLP Funds and Taxes), funds such as these convert the K-1s they receive into the 1099s desired by their investors by paying corporate income tax on their returns. The result is that an investor in a C-corp MLP fund such as this earns substantially less than the index – somewhere close to 35% less since that’s the portion ultimately paid to the U.S. Treasury.

It’s all disclosed in the prospectus, and credit Ron Rowland for first pointing out this pretty fundamental weakness back in 2010. But it turns out few investors or their financial advisors make it to page 5 of the document where the paragraph on “Tax Status” explains that AMLP is a corporate tax payer.

March 13 2016 Blog Chart 1

The result, as would have been clear to anyone who carefully examined the fund’s structure and is shown in the first chart, was that AMLP lagged the Alerian Infrastructure Index (AMZIX) from its launch until the market peak in August 2014. Then as the market turned down, AMLP fell less quickly, since it had an accumulated Deferred Tax Liability (DTL) on which to draw. It provided, in an odd sort of way, less volatile exposure to MLPs because the taxes acted to dampen movements both up and down.

The second chart shows monthly returns for AMLP alongside AMZIX since its launch in 2010. Visually, you can see that the moves in AMLP both up and down are generally less than the index against which it is benchmarked.March 13 2016 Blog Chart 2

In August 2015, a year into the MLP bear market, this relationship changed in a way that was disadvantageous to the AMLP investor, in that AMLP began matching the moves in its index rather than moving less than the market. The reason is that AMLP had exhausted its DTL. Taxes are owed on unrealized gains, and the market had fallen far enough to wipe them out completely. As those gains became losses due to further drops in MLPs, AMLP was unable to carry a Deferred Tax Asset (DTA) because of its status as an open-ended investment company. While an operating company can offset losses against future taxable gains, AMLP and its peers cannot.March 13 2016 Blog Chart 3

The third chart focuses in on the monthly swings in AMLP and AMZIX since August 2015 to show that they are much more closely matched.

This is an extremely poor bargain for AMLP investors, because since then they have continued to absorb 100% of the losses in the market but on a recovery, as soon as AMLP gets back to having unrealized gains on its portfolio the taxes will kick back in and investors will once more only receive 65% of the upside. It’s like betting $100 on red at Roulette knowing you’ll only get paid $65. In July 2015 we forecast that this would happen if prices continued to fall (see The Sky High Expenses of MLP Funds). It’s likely that all taxable MLP funds face the same return asymmetry, since MLPs fell far enough to wipe out unrealized gains across the board.

The tax drag shows up in the expense ratio, which for AMLP is currently an eye-popping 5.43%, of which 4.58% is taxes. Virtually no-one I’ve spoken to who’s invested in AMLP is aware of this, as I know from numerous conversations on the topic. The discovery is invariably met with a combination of horror and embarrassment.

The yield on AMLP doesn’t reflect the tax drag, because the taxes come out of the NAV. So while Morningstar lists the yield as 11.81%, a discerning investor would deduct the 4.58% tax drag from this figure to arrive at 7.23%, substantially below the yield on AMZIX.

The defense of the fund’s structure is that it provides MLP exposure without the K-1s, and it does that after a fashion. But in my experience few investors truly comprehend the substantial loss of performance they suffer because of this. It’ll be no surprise to its designers, but AMLP has underperformed its benchmark over every time period since inception other than last year when the tax drag temporarily reduced its downside.

In fact, AMLP’s structure made it the perfect shorting vehicle for hedge funds seeking to bet against MLPs last year, and there is ample anecdotal evidence that this was going on. The asymmetry of its returns (up 65% of the market/down 100% of the market) clearly works to the benefit of the short. In addition, while shorting a security renders you liable for the dividends paid to investors, AMLP’s expense ratio was a substantial mitigant because the tax drag reduces the NAV. In this way, the tax costs incurred by the investors act to reduce the financing costs for shorts, so AMLP investors by owning the security were aiding the very market participants whose objective was to drive down prices and force them out of their investment with losses. Given how MLPs performed last year, hedge funds shorting AMLP evidently enjoyed some success.

The Mainstay Cushing MLP Fund (CSHAX) is similarly structured and invariably underperforms its benchmark. Portfolio Manager Jerry Swank was asked by Barron’s in June 2012 why the fund had lagged its benchmark since inception in 2010 and he replied, “As a corporation, what a mutual fund gives up is a tax drag on the net asset value, as much as a 38% tax drag on NAV.” CSHAX has an expense ratio of 9.42%, of which 7.94% is taxes.

The questioner should have asked, ‘Can you really claim to put investors’ interests first if you design a vehicle like this?’ Instead she moved on, but really; who seriously expects a mutual fund to pay away almost 8% of its clients’ capital in taxes? Funds such as these rely on the cursory examination most retail buyers give to the terms of their investment. They trust finance professionals to recommend thoughtfully designed securities, and that trust is not always well placed.

These securities and others like them (we calculate there are around $20BN outstanding) are deeply flawed. They exploit the unfortunate proclivity of many investors towards superficial research and while their shortcomings are disclosed in documents they’re certainly not understood by their investors.

If you own AMLP, CSHAX or any of the other highly-taxed MLP funds (the clue is a high expense ratio), all is not lost. While their purchase was an error, you can sell now and take the tax loss, maintaining your exposure to a deeply undervalued sector with a RIC-compliant MLP fund properly structured so as to not be a corporate taxpayer. And if your financial advisor has invested your money in a taxable MLP fund, call and ask him if he knows what the expense ratio is that’s eating away at your investment. He’ll probably pay closer attention to fund structure in the future.

Insiders Are Reinvesting Back into MLPs

It’ll be a while before Master Limited Partnerships (MLPs) will fairly be described as no longer in a bear market. So far the low point was on February 11th, at which point the Alerian Index was 58.2% below its all-time high of August 2014. The following day, SEC filings revealed institutional purchases by Berkshire Hathaway (BRK), hedge fund Appaloosa and the Oklahoma Teachers Retirement System (see Real Money Moves Into Real Assets), and this seems to have been the catalyst for a modest improvement in investor sentiment. Rising crude didn’t hurt either, and the result has been that the 30.2% three week bounce in MLPs since that February 11th low is the largest rally since making their August 2014 high.

A technically driven rally is nice, but it’s also interesting to see the level of insider buying in recent months. Just among eight stocks that we follow, we’ve calculated almost half a billion dollars of insider purchases over the past twelve months. Enterprise Products Partners (EPD) is the biggest at $185MM, funded in part by the constant reinvestment of distributions by management. Other purchases of note include $108MM at Energy Transfer Equity (ETE). Crestwood Equity Partners (CEQP), a speculative and therefore appropriately small investment of ours, saw insiders purchase a startling 9.4% of the public float during 4Q15. Tallgrass Energy GP (TEGP) also saw insiders buy 1.7% of the float. It’s worth remembering that these purchases and others are generally funded by distributions paid out to those very same investors. MLPs are highly cash generative businesses.

  Selected Insider Buying in Past 12 Months
Company Ticker Amount ($MMs) % of Float Purchased
Crestwood Equity CEQP 90 9.4%
Enterprise Products EPD 185 0.5%
EQT GP Holdings EQGP 5 0.8%
Energy Transfer Equity ETE 108 0.4%
Kinder Morgan KMI 43 0.1%
NuStar GP Holdings NSH 16 1.8%
Plains GP Holdings PAGP 16 0.9%
Tallgrass Energy GP TEGP 23 1.7%

 

There have been other informed buyers beyond the institutions and insiders mentioned above. Plains All America (PAA) issued $1.6BN in convertible preferred units to a group of private equity investors that were already invested in Plains and therefore know the business well. They included EnCap Investments, First Reserve and Stonepeak Infrastructure Partners. Targa Resources (TRGP) issued $500MM in similar securities to Stonepeak.

I was chatting with a friend who is a financial advisor the other day, and I asked him what sector of the equity market (apart from MLPs) offers the best opportunity right now. He felt that low volatility, dividend paying stocks could provide a return of better than 10% over the next four quarters. We like that sector too, and we have run a Low Vol Strategy for many years that regularly generates attractive returns (see Why the Tortoise Beats the Hare). It’s a great place to be invested. And yet, there are MLPs yielding well over 10%.

As we noted in last week’s blog (MLP Managements Talk Business), any equity security which confounds the skeptics by paying its dividend for a year will, assuming this draws in additional buyers that drive its yield down by 2%, deliver a 30%+ total return to those who invested a year earlier. Many MLPs still offer this possibility. Given the collapse in MLPs since August 2014, they ought to offer this kind of potential return. In early February after only 9 business days, MLPs were down 19%. Today’s MLP investors have endured some torrid days. But if you invest where you assess a high probability of continued distributions, it’s hard to think of another asset class or sector that comes close. There’s increasing evidence that insiders and institutional investors are acting on that belief.

By way of example of the high yields in the sector, Williams Companies (WMB) on Friday declared a $0.64 dividend. At $19.15, where it closed on Friday, this would be a respectable 3.3% yield if the $0.64 was an annual dividend. But it’s actually a quarterly dividend, so WMB yields 13.37%. Some investors were probably not expecting another WMB dividend so it was a welcome surprise. If the merger with Energy Transfer Equity (ETE) goes through on current terms, when it closes WMB investors will receive dividends of $1.74 annually from the 1.5274 shares of Energy Transfer Corp (ETC) they’ll swap for their WMB shares. But they’ll also receive a one-time $8 cash payment plus a $0.10 special dividend,  so $1.74 on an $11.05 stock price ($19.15 less the $8.10 payments) is 15.75%. The Presidential election is not the only thing that can make your jaw drop.

We are invested in BRK, CEQP, EPD, EQGP, ETE, KMI, NSH, PAGP, TEGP and WMB

Wall Street Potholes — Insights From Top Money Managers on Avoiding Dangerous Products

On Monday, March 14th at 6:15pm, at the Hilton Hasbrouck Heights, Hasbrouck Heights, NJ, I’ll be giving a presentation on my new book, Wall Street Potholes,  to the American Association of Independent Investors, Northern New Jersey Chapter. There is a modest entry fee. I’ll also be giving a similar presentation on Wednesday, March 23rd at 7pm at the Westfield Memorial Library, Westfield, NJ. Attendance is free.

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