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Roger Conrad
Roger Conrad
Articles (204)  | Author's Website |

Take Advantage of Mispriced MLPs

February 16, 2012 | About:

Despite economic uncertainty and the EU’s ongoing sovereign-debt crisis, a reprise of the financial meltdown and credit crunch of 2008 appears unlikely for the time being. Corporations can still borrow money at extraordinarily low rates, a stark contrast to the tightened credit conditions that prevailed in 2007 and 2008.

Most companies have taken advantage of the benign rate environment to extend near-dated bond maturities, a move that has limited their short-term credit needs. That being said, credit is the lifeblood that enables MLPs to acquire assets and invest in growth projects; an extended credit crunch could stunt distribution growth.

After the stock market swooned in two consecutive summers, investors should be prepared for equities to follow a similar pattern this year, particularly with the presidential election on the horizon and uncertainty regarding future tax policy. Unforeseen events such as the Arab Spring and the magnitude-9.0 earthquake that hit Japan in March could also shake up the stock market.

By and large, U.S. equities weathered the storm in 2011, eking out a slight gain despite the breakneck volatility.

However, MLPs face a new challenge in 2012: valuation. In the current environment, interest rates no longer drive stock prices for MLPs and other dividend-paying fare. In fact, MLPs frequently rally when the yield on the 10-year Treasury note increases and trade lower on days when this yield declines.

Like other dividend-paying equities, MLPs are following a different yield curve than in previous periods. Fear of inflation and rising interest rates has taken a back seat to investors’ perception of dividend sustainability. The greater the perceived risk of a dividend cut, the more selling pressure a stock will face. Safe havens, on the other hand, tend to attract buyers and have lower yields.

When fear rules the ticker, the yield curve steepens dramatically, widening the gulf between the yields on “riskier” and “safer” MLPs. When investors grow more optimistic and are willing to take on additional risk in exchange for higher yields, the curve flattens.

Of course, the market’s perception of risk doesn’t always reflect reality. Stocks that are in motion tend to stay in motion. That is, the market tends to pile into names that are appreciating in value because they assume these stocks entail less risk. The same principle applies on the downside: When an MLP’s unit price declines, investors assume that the risk of a distribution cut has increased, a perception that engenders even more selling.

Investors who focus on fundamentals rather than sentiment have ample opportunity to take advantage of the market’s inefficiencies. Genesis Energy LP (NYSE:GEL), for example, returned 13 percent in 2011, less than half the gain posted by units of Kinder Morgan Energy Partners LP (KMP). However, Genesis Energy grew its distribution by 10 percent in 2011, whereas Kinder Morgan Energy Partners increased its payout by only 2.6 percent

The difference-maker: The market regards Kinder Morgan Energy Partners’ distribution as far more secure than Genesis Energy’s payout. But higher payouts will drive share price growth over the long term.

About the author:

Roger Conrad
Investing Daily provides stock market advice and investment newsletters to help independent investors achieve a secure and rewarding financial future. The site’s coverage focuses on finding the most profitable emerging trends in the investment universe to bring investors pragmatic and in-depth coverage of the names that are taking advantage of these opportunities.

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