Why Market Timing Can Be Seductive

We generally don’t keep CNBC on at our office. Its relentless focus on the short term, punctuated with incessant commercials, make it a needless distraction. That’s why they hire attractive presenters. However, when passing the office next door I did notice a headline saying we’d gone 33 consecutive days without a 1% move in the stock market.

I presume it’s a record of sorts – there has certainly been a dearth of market-moving news lately. It reminded me of that frequent advice to stay invested because a relatively small number of months provide a surprising amount of the total return. And it’s true; using S&P data back to 1900, totaling 1,400 months, had you by some terrible misfortune been out of the market for the ten best months your $1 invested in January 1900 would have only grown to $70, rather than $363 if you’d stayed in the whole time. Mind you, even if you “only” had the $70 at the end of 1,400 months, you’d still have achieved success by longevity and probably wouldn’t care about the money.

Obviously when investors temporarily exit the market, they’re trying to avoid the bad months not miss the good ones. And here’s the thing that’s perhaps not intuitive; if our investor, in missing the ten best months also managed to skip the ten worst ones, he’d be better off than if he did nothing with a terminal wealth of $493.

This places the folly of market timing in a somewhat different light. Under the circumstances, perhaps trying to avoid the bad months is a worthwhile objective since they are disproportionately more damaging. Surely, you’re just as likely to miss a bad month as a good one, or indeed equally likely to miss the worst month as the best?

Sadly, like most investment models that can be thrown together in thirty minutes on a spreadsheet, it’s not that simple. Our market-timing investor is unlikely to miss the best or the worst months, but will probably miss the typical months. Because more months are up than down, the typical monthly return is positive. Since January 1900 we’ve had 828 up months, 59% of the total. The likelihood is that by chance he’ll miss more up months than down ones, and his overall returns will be worse.

The Shrinking Pool of Cheap Assets

Stocks have in recent years been the destination of choice for bond refugees. The guiding strategy behind monetary policy since 2008 has been to drive investors into riskier assets so as to boost economic growth. Amid mounting evidence that this objective was being achieved, the Federal Reserve has contemplated the timing around ending this strategy by normalizing rates. In fact, the Federal Reserve has provided so many false warnings of an impending tightening of monetary policy that it’s barely worth paying attention. I have kept track of their evolving rate forecasts ever since they began providing greater precision back in January 2012. The chart of “blue dots” represents individual FOMC members’ expectations for the Fed Funds rate. Four and a half years ago they kicked off this greater openness with a forecast of a single tightening that year and a 0.75% rate by 2014. It’s fair to say that in early 2012 none of them expected the August 2016 funds rate to be where it is at 0.25%. Ever since they started with the blue dots, they’ve strained to adapt their updated forecasts to their persistent inaction.  It has been an amusing if not especially informative spectacle. You’d think it would be easier to get it right than the record suggests — they are, after all, merely trying to forecast their own actions. However, tactics regularly overwhelm strategy, as a moment of weakness in any sector of the economy is extrapolated into the possibility of a disappointing GDP number. If you look hard enough, there’s always softness somewhere. FOMC members possess many skills, but good forecasters they are not.

Not everyone has been surprised by the lethargic return to “normal” interest rates. Since it is the political season (i.e. shameless self-promotion is all around us), back in 2013 your blogger noted high levels of public debt and concluded that, “As a society we want low rates, and the Federal Reserve is pursuing a set of policies that are clearly in the public interest.” See Bonds Are Not Forever; The Crisis Facing Fixed Income Investors (Wiley, 2013).

Consequently, interest rates have remained lower for far longer than most investors expected. Every fixed rate mortgage has turned out to be more expensive than going with an adjustable one. Every non-defaulting corporate bond issued was, in hindsight, more costly than relying on floating rate debt. Eventually a borrower somewhere will lock in an all-time low in rates, but it hasn’t happened yet.

It’s not hard to find examples of strong performance in bonds, but even by recent standards I found the chart below from the Financial Times striking. The UK may have voted itself a recession via Brexit, but among the winners are holders of long-dated Sterling denominated corporate bonds whose prices in some cases have reached two times their par value at maturity.

Because of continued central bank monetary accommodation, the indices touching new highs are many and varied. Stocks, bonds, utilities and REITs are all at or very close to all- time best levels. As a result their yields are all commensurately paltry, as one might expect. By comparison, energy infrastructure, as represented by the Alerian MLP Index, offers both a substantially higher yield and a meaningful discount to its former high. With so many asset classes trading at hitherto unseen levels, it’s increasingly difficult to identify pockets of value. Momentum investors of course have plenty of choices, since so many sectors have strong upward momentum. MLPs have been no recent laggard on this score either, having leapt 60% from their low this past February. But it seems to us that if you like your investments to offer some kind of value cushion for when the momentum inevitably turns, MLPs should hold your attention. The yield spread between MLPs and REITs remains close to the widest levels it reached during the 2008 financial crisis. Switching from REITs or Utilities into MLPs looks like a portfolio upgrade.

Energy Transfer's Gift Is Less Than It Appears

For information on our MLP mutual fund, please click the link below:

Mutual Fund

Last week’s blog post (Williams Satisfies Two Masters) highlighted the different views of cash payouts by the MLP investors who hold Williams Partners (WPZ) and the C-corp investors who hold Williams Companies (WMB), the General Partner of WPZ. WPZ investors value regular payouts whereas WMB investors are driven by total returns. WMB neatly gave both types of investor what they desired by diverting WMB dividends to buy new WPZ units which provided cash to fund WPZ’s capex program, and thereby eliminated the risk to WPZ’s distribution. One of the powerful features of the GP/MLP structure is that is allows a business to access different classes of investors who can have different objectives. As their appetite to provide capital fluctuates, the GP/MLP can access the more willing investor class.

Continuing this theme, Energy Transfer similarly found a way to make everyone happy with the same set of assets.  CEO Kelcy Warren is masterful at moving cashflows and businesses around to find value. Aligning your interests with Kelcy Warren works most of the time, even if he is occasionally ethically challenged (see Is Energy Transfer Quietly Fleecing Its Investors?).

On their recent earnings call, Energy Transfer Equity (ETE) generously announced that it would waive $720MM of Incentive Distribution Rights (IDRs) due from Energy Transfer Partners (ETP) to ETE over the next 6 quarters.  IDRs are the payments an MLP makes to its GP and are somewhat analogous to the incentive fees a hedge fund manager earns from his hedge fund. ETP traded up following the announcement of this largesse, and ETE traded down.  On the surface this is a straight transfer of value from ETE to ETP, a movement of cashflow from one pocket to the other. It’s a zero-sum transaction.

The ostensible reason is to support ETP’s stock price which will make it easier to sell new units of ETP. On the previous earnings call, Kelcy said: “In order to support ETP with its cost of equity capital in light of ETP’s current common unit price, ETE has recently advised ETP that ETE intends to waive its rights to receive incentive distributions, with respect to ETP’s 2016 issuances of common units… whether pursuant to the ATM or other offerings of common units, through fourth-quarter 2017 distributions. As these potential IDR waivers have not been approved by the ETE board, ETE is not formally bound to these proposed IDR waivers. This reinforces ETE’s commitment to support ETP.”  On the same call, Kelcy noted that, “ETE will do what it needs to do to support ETP”

ETP rose 10% on the day of the announcement.

Although the conference call made it sound like an altruistic move by ETE, the relevant SEC filing noted that in exchange for these IDR waivers ETP was granting ETE new Class J units which would transfer $1.8BN of ETP’s depreciation, depletion and amortization (“DD&A”) to ETE over a period of three years (2016-18). Both ETP and ETE are partnerships issuing K-1s, so the proportional share of depreciation runs through each investor’s tax return. ETP investors will in aggregate have $1.8BN less in tax-deductible depreciation expense, approximately $3.44 per unit (there are 524MM ETP units outstanding). Assuming a 45% marginal tax rate (K-1 tolerant MLP investors are usually in the top rate) the taxable ETP investor is $1.55 per unit worse off. The IDR waivers work out to be worth $1.37 pre-tax per unit. So it’s at best a wash.

Prior statements from ETE include an assertion that ETE would not suffer any reduction in cashflows from ETP, and on the most recent conference call, Kelcy confirmed that there would not be additional IDR waivers applied to new equity raised at ETP. The IDR forgiveness is not equally spread over six quarters but is modestly back-ended. Therefore, we deduce that ETP will issue additional equity which will pay IDRs to make up for the shortfall from this IDR waiver. The rise in ETP’s stock price that followed this announcement makes it a little easier to issue equity. It also shows that ETP is valued, like other MLPs, on a pre-tax basis.

While MLP investors are drawn to the sector because of the tax-deferral that depreciation charges afford, few calculate their effective after-tax return on each individual security. They just send the K-1s to their accountant, who grumbles while charging a bit more, and the investor winds up with a lower tax bill. Figuring out which MLPs one holds are the most tax-effective is beyond most investors’ interest or ability. After-tax returns are notoriously quixotic and vary based on an individual’s tax situation. ETE management has insightfully spotted this. For this reason, most investment analysis relies on pre-tax returns. And sure enough, Barron’s quoted four analysts who gushed about the IDR waiver while ignoring the loss of tax shield (see Energy Transfer Partners Gets Fee Break from Parent, Shares Rise).

Kelcy has figured out that if investors don’t value something that highly you might as well give it to someone else. ETE investors (of which Kelcy is 18%) value the tax shield more accurately, which is clear since ETP’s stock rose even though the after-tax outcome for ETP investors didn’t add any value. Meanwhile, not only does the swap of tax shield for IDR waivers leave ETE investors better off after tax, but ETP can now issue new equity more easily, which will throw off additional IDRs for ETE indefinitely. The IDR waiver is expected to be $130M in 4Q17 after which it expires.  Starting in 2018 ETE will receive $520M more in IDRs each year for its “support” in which it gave up no cash flows and received $810M of value in DD&A units. Those Energy Transfer people are pretty clever.

We are invested in ETE and WMB

Just so it doesn’t seem as if we only pick on Energy Transfer, here’s a link to a recent TV spot on hedge funds.

Williams Satisfies Two Masters; More on Solar

Williams Satisfies Two Masters

Master Limited Partnership (MLPs) have been reporting earnings over the past couple of weeks. They were largely as expected with several names providing modest positive surprises. There were also some other interesting announcements – notably the sale by Energy Transfer Partners (ETP) and Sunoco Logistics (SXL) of part of their interest in the Bakken Pipeline Project to Enbridge Energy Partners (EEP) and Marathon Petroleum (MPC).

We calculate that ETP and SXL collectively invested $2BN developing this asset and have received $2BN for a partial interest, leaving them with a significant economic stake for minimal cash outlay. In addition, they removed competitor project Sandpiper by bringing its sponsors into their project and MPC’s refineries will be an important customer which could provide an uplift to volumes.  The value of the assets and backlog of the Energy Transfer Family is why we’re invested for now in ETP and SXL’s General Partner (GP), Energy Transfer Equity (ETE). This is in spite of misgivings about management who remain unapologetic about acting in their own self interest (see Will Energy Transfer Act With Integrity?). On this topic we salute friend Ethan Bellamy, R.W. Baird’s Senior Analyst covering MLPs, for shunning the usual, sycophantic “great quarter guys” posture of most analysts and asking CEO Kelcy Warren a direct question on his crooked converts.

But our focus this week is on Williams Companies (WMB). As they warned before the vote on their ill-fated merger with ETE, a dividend cut was coming and was duly announced this week. In the meantime, a failed effort to fire CEO Alan Armstrong resulted in six of thirteen board members resigning.

Dividend cuts usually reflect strategic mis-steps by management, and although WMB controls a unique asset in Transco (an extensive pipeline network covering much of the eastern U.S.) their stock has lagged the Alerian Index substantially over the past two years. CEO Armstrong might argue that the influence of activists led by Keith Meister (an investor whose long term advice is of dubious value, as we wrote in  The Corvex Discount) forced poor strategic decisions. The pending sale to ETE limited WMB’s ability to make any other moves, such as raising capital, until it was resolved.

But in this case WMB is using the cash saved from its reduced dividend to fund its growth capex, most of which is going to expand its Transco asset at attractive multiples. Although WMB cut its dividend by 70%, its MLP Williams Partners (WPZ) maintained theirs and both securities rose on the news. It was a perfect illustration of  the divergent views of dividends. WMB investors are total-return oriented and cheered the redirection of cash into high-return projects. WPZ investors just want the cash. Both classes of investors are getting what they want.

It reflects a different approach to the Sponsor/MLP model. Traditionally, the sponsor develops the assets and then sells them to its MLP through a “dropdown” transaction. The MLP raises capital through a secondary offering of equity (usually supplemented with debt) and uses the cash raised to pay its sponsor for the asset.

 

This model broke down last year as MLP yields rose to levels that made equity financing prohibitive. And yet, many attractive investment opportunities remained. It illustrates that the problem with midstream MLPs last year was not poor operating performance but a need for growth capital in excess of traditional investors’ desire to provide it (see The 2015 MLP Crash; Why and What’s Next).

Prior to the WMB dividend cut, WPZ yielded 9.7%, representing an expensive cost of equity capital. The 70% cut in WMB’s dividend will save $1.3BN annually. WMB expects to invest $1.7BN through the end of 2017 in new WPZ units. WPZ will use this cash to fund its capex, thereby eliminating its need to issue equity to the public and also taking pressure off its distribution.

WMB can in the future sell the WPZ units it will be acquiring through the next five quarters when the market environment is better and yields are lower. It’s an elegant way to provide WMB C-corp investors what they want (invested capital in high return projects) and WPZ investors what they want (stable distributions under any and all circumstances). Because the two classes of investors have different objectives, there are different times to access them for capital. Today the C-corp investor is more receptive, whereas MLP investors are setting a higher price. In time the cycle will shift, and the MLP investor will be a more eager capital provider, at which time WMB may sell its WPZ units. Crucially, the Incentive Distribution Rights (IDRs), under which WMB earns 50% of WPZ’s incremental Distributable Cash Flow (DCF) will remain with WMB even after the WPZ units are sold. It’s like a hedge fund manager investing his own cash in his hedge fund when investors are hard to find but opportunities attractive, and later on replacing his capital at a profit with outside investors’ money which will pay the ubiquitous “2 & 20”.

This is why it’s better to invest in MLP GPs.

We are invested in ETE and WMB

More on Solar

We received quite a few comments on our August newsletter (see Why Electric Cars Are Good for Fossil Fuels). We see solar-derived electricity generation growing at a high rate, but maintain that electric cars will for the foreseeable future consume electricity that is largely derived by burning natural gas and coal.

There are solar bulls who forecast that the sun will provide a substantial portion of our electricity in less than a generation (see Ray Kurzweil: Here’s Why Solar Will Dominate Energy Within 12 Years). Mr. Kurzweil’s Wikipedia page lists him as a computer scientist, inventor and futurist. He works for Google, so is a seriously smart guy.

So we won’t take on Mr. Kurzweil’s forecast directly; I’m personally a late adopter on most new things and on solar domination well, I’m just not quite there yet. But an important challenge for solar is that U.S. electricity consumption is barely growing, rising at 0.5% annually since 2000 according to the Energy Information Administration’s Annual Energy Outlook 2016. So to be significant quickly, solar will have to gain market share from traditional sources of electricity generation – and it is expected to gain at the expense of coal (as is natural gas). But to become the dominant source of electricity it will have to undercut many power stations that still have years of useful life ahead of them.

Moreover (as my partner Henry so insightfully noted), to do so they’ll need to deliver electricity not simply cheaper than the fully-loaded cost of a power plant but below its marginal cost. A nuclear power plant involves a high up-front cost to construct. Thereafter, its operating costs are the threshold for any new, competing source of electricity. As in micro-economics, once your fixed costs are spent, as long as you cover your variable costs you’ll keep producing widgets (or Megawatts). Power plants last for decades, so the openings for solar even if competitively priced will occur very slowly as less efficient plants are retired.

Furthermore, utilities and municipalities account for two thirds of U.S. gas transport capacity (pipelines) and sign long-dated volume & price commitments, making a quick switch ever more cost-prohibitive.  Replacing retired coal capacity is how natural gas is making inroads into coal (although expensive environmental regulations are hastening the process). For these reasons and a lot of others specific to the intricacies of the electric utility sector (including load balancing and regulations), we think solar will grow and yet fail to be dominant for decades, similar to all past transformative energy technologies.

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