MLPs in the bargain bin – setting up for Q4/Q1 rally

We’re in the midst of a post election, fiscal cliff sell off with the stock market trying decide which way its going to head based on every single new headline out of Washington. Its usually best to avoid getting  into this tug-of-war and wait until things settle out, unless you have a very short time frame. With that in mind I’ve been looking at MLP valuations and think there is some compelling value in the sector an that it is potentially setting up for a nice rally for the remainder of the year and into Q1, in particular if some of the macro headwinds clear. At the very least, it is time to start making an MLP shopping list and planning entries.

First, lets take a look at the valuation of the MLP sector both on an absolute and relative basis. The chart below shows the historical dividend yield of the MLP sector and the relative value vs the 10 yr US treasury (measure by the spread – yield difference – between the two).

The current yield of the MLP sector is 6.6% vs a historical average of 7.04%. By this metric you could say MLPs are slightly over valued. By the relative metric of yield spreads, MLPs are very cheap with a spread of 502 vs an average of 334. So which metric is the better one to use? Historical spreads are usually a better indicator of potential future returns than absolute yields. Absolute yields can be deceiving sometimes – in particular with MLPs – which are a relatively new asset class. The market cap of the entire MLP sector in 1995 was $5B whereas today the market cap of MLPs is about $275B. In 1996 there were less than 20 MLPs whereas today there are about 80 MLPs. Its like comparing small cap valuations to mega cap valuations. Turning to spreads we can look at what todays historically cheap spreads tell  us about potential future returns. The chart below give us that indication.

Historically spreads at today’s levels have led to subsequent 12 month returns of 39%. Many would argue that these high spreads are due to artificially low US treasury yields. Maybe but I don’t think so. What these people miss is that yields are low for a reason, slow economic growth, and rates will stay low at least into 2015. When they rise they will rise due to higher economic growth. I don’t think in the current environment we’ll see 12 month returns of 40% for MLPs but it wouldn’t surprise me to see 20% returns over the next 12 months. A final impetus could come from the January distribution capture effect on MLPs. As I described in this post, the bulk of MLP returns have historically come during 4 months of the year, with January being by far the best month. All in all things look pretty good for MLPs.

A quick note on MLP fundamentals. I don’t talk about this much because I hope its self evident by now. The US in the midst of a huge boom in energy and energy related infrastructure. This is probably one of the biggest and also one of the few bull markets out there today. And that is the base fundamental reason that is driving MLP returns and will continue to so in the future. MLP were good investments prior to the start of the boom in 2006/2007 and they are even better now. In fact distribution growth in MLPs has accelerated in recent years even as the sector has  grown more than 50 fold since 1996. And we are still in the early stages of this growth. The forecast for US energy infrastructure spend is about $300B over the next 15 years or so.

Lastly, what are best MLP investments right now. Investing in the individual MLP names is the best way to go. The MLP ETFs and CEFs all have issues as I’ve discussed in the past. The biggest, most diversified names are the safes bet in the current macro environment. You never know when some political comment will send the SPY over its own cliff these days. Names such as EPD, KMP/KMR, MMP. PAA, and OKS are pretty good bets here. Personally, I’m looking more for distribution growth and for some names that have been unreasonably hit since the election. My list of favorites right now are NGLS/TRGP. WMB, KMI, MWE, EPB. On the more speculative front I’d be a buyer of LNG and GEL at the right prices. What I would recommend is to make your list of top buys based on fundamentals and technicals, pick your position sizes, and plan to enter in stages to avoid some of the potential fiscal cliff impacts.

In summary, MLPs are quite cheap today and could possibly stage a nice rally through the end of the year and into Q1. They also are attractively valued based on long term fundamentals. And on the macro front, post any fiscal cliff solution which will involve some form of higher taxes, MLPs will be even more attractive going forward.