MLP valuation – cheap yet again

For my first post back from my break, I’d like to focus on the valuation of one of my favorite sectors, MLPs. I’ve posted on MLPs many times before (see here for a list of posts) and my largest single stock position for years has been Enterprise Products (EPD). Bottom line, MLPs are cheap yet again and present a nice entry point for long term investors.

The best way to judge the valuation of MLPs, and almost all income based investments, is to look at spreads to US treasuries, in this case the difference in yield between the MLP index, AMZ, and the yield on the 10 year US Treasury note. Then compare that spread to its historical pattern. The chart below shows the the MLP to 10yr spread going back to 1999.

A large spread, a high number, indicates that MLPs are cheap relative to gov’t bonds and usually leads to good returns in the near future and a return to smaller spreads. For example, last year in October, MLP spreads touched the upper red line, indicating that they were very cheap. Subsequently MLPs had a very nice rally into the end of 2011. Looking at the chart a similar thing happened in 2010. And now it looks like the same thing is happening for the 3rd year in a row. In early June the AMZ was almost 20% off its recent high. While there has been a nice 10% bounce since then, the MLP spread is still quite high. OK, great. What kind of opportunity are we talking about here? Lets take a look.

The chart below is a little complicated but quite revealing. It shows MLP spreads vs subsequent 12 month total returns. In other words, if you had invested in MLPs when spreads were in the given range your total return, on average, one year later would have been what’s indicated on the chart.

A few important things to note here. The gray bar shows where we were on July 6th. The MLP spread was 474bps (4.74%). The chart shows the historically when spreads are in this range the average subsequent one year total return for MLPs has been 39.66%! A few weeks ago spreads were over 500bps, returns from that point have averaged just over 40%. The really important point for me is that when MLP spreads have been over 465bps there has never been a subsequent 12 month period with a negative total return. This includes the financial crisis when spreads having crossed 500bps proceeded to blow out to over 1000bps. There has been only 3 or 4 other times in MLP history when they have been this good a value.

Where have I been looking? Well, I always look at the big boys first. The likes of KMP/KMR, EPD, PAA, OKS, etc… If there are any issues ahead that we can’t see the big stable MLPs will weather the storm the best. KMR had a large sell-off that was too good to ignore. Take a look at the chart below. From $70 to $78 in less than two weeks. Even better, at $70 KMR was yielding close to 7%.

In summary, MLPs are cheap. They have rarely been cheaper. There could be some unknown out there which drives values lower but the risk/reward setup is darn good right now in particular for long term income investors.