It’s a good time to update the valuation for one of my favorite sectors for income investors and retirees, MLPs. MLPs had another great year in 2011, especially during Q4. The sector returned 14% for the year vs 2% for the SP500. I’ll spare everyone the suspense buildup of the next 600 words or so and say that I think that the sector is slightly overvalued on a short term basis but many individual MLP names are offering good value. On a longer term view the sector is still very compelling. As I write this on Jan 13, 2012 there is a bit of a sell off going on in MLPs so far in Jan which I think is quite a healthy thing and will most likely present some good entry points for investors looking to add funds to this sector. Lets look at some details of MLP valuation right now.
Overall, the best relative valuation metric for the MLP sector is its yield spread to the 10 year treasury. I’ve shown this chart many times in the income investor dashboard. Here is the MLP spread and also the ones for investment grade bonds and for high yield bonds, two sectors that often compete for funds with MLPs.
These charts show the MLPs still offer a good value relative to their historical values and relative to corporate and high yield bonds. On a short term basis however the sector look a bit frothy. Lets look at a recent chart of AMJ, the main MLP ETF.
As the AMJ chart shows. MLPs have had quite a run from the Oct 2011 lows. A pull back is well in order. I would love to see a pull back to at least the 50 day SMA or the lower bollinger band. Even a pull back to the 200 day SMA would not be a shock but I think its unlikely in the current environment.
Just like the overall market I don’t invest in the MLP index. I think individual MLP names are much better investments than the index. In individual names the stories of value can be quite different. For example, in 2011 the best MLP performer was EVEP with a gain of over 70% while the worst performer was NKA with a loss of over 50%. I like to use the magic formula to value any income investment. Basically, I rank investments on total return and calculate total return as the sum of the current dividend plus dividend growth. I’ve done this for a list of MLPs that I follow. See below. The dividend growth numbers come mostly from the companies themselves and in some cases analyst estimates in cases where the companies don’t provide estimates. Right now the general partners of the MLPs are offering better value than the limited partner shares.
Based on this type of analysis I rotated some of my MLP holdings in Q4 of last year. I sold KMP and rotated into KMI and I also sold ETP and rotated into some ETE and also initiated a position in WMB and VNR. All else being equal I’m always looking for higher total returns. There are always key individual situations in each company that can provide investors even better investments than that suggested by total return forecasts alone. For example, I chose KMI because the pending acquisition of EP is going to provide an even better dividend boost this year than forecasted. I chose WMB because of the spinoff value of WPX plus I think they’re sandbagging their long term forecasts. And finally I chose VNR also because I think growth will be much better than expected as they grow their market cap via future acquisitions.
In summary, in the short term MLP valuation appears over extended but the sector offers good long term value and very solid fundamentals. General Partners also appear to be offering better value than the limited partner counterparts.
Disclosure: long EPD, KMI, VNR
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.