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MLPs: Recent Bad News Leaves Valuations Extremely Attractive
On March 15th, the Federal Energy Regulatory Commission (FERC) announced that it will no longer permit income tax allowances in cost-of-service rate agreements for pipeline MLPs. Sounds bad, right? That is what investors thought. Almost immediately, p
ublicly traded MLPs took a hit, with some partnerships losing more than 10% of their market value. However,
if investors had spent time on the details of this announcement, they would have understood that this policy change does not affect all MLPs.
Background
Master limited partnerships (MLPs) are interesting investment vehicles. Their first notable characteristic is their high yields. Most publicly traded MLPs trade with yields above 5%, making them ideal for investors that need to generate current portfolio income. The second defining characteristic of MLPs is their tax efficiency. MLP distributions are partially composed of a return of capital, which reduces an investor's cost basis and allows them to defer tax until they sell the security.
One downside to investing in MLPs is that they are complex and broadly misunderstood by investors. This results in a higher-than-average level of price volatility.
For evidence of this, one needs to look no further than last week's trading activity. The MLP sector experienced significant price declines after the policy change was announced, The Alerian Index which tracks 40 partnerships had its worst day in 2+ years.
Impact of the FERC Rule Change
Although the ruling caught some investors by surprise, the impact will actually be fairly narrow. Here's why. Interstate pipeline MLPs can calculate the fees they charge to their customers in two different ways:
- Cost of service rate agreements
- Other rate agreements
It's the first method (cost of service rate agreements) that will be impacted by this change.
However, many MLPs use other rate agreements. Additionally any MLP which is structured as a C-corp can't use the cost of service rate agreements. Other areas of the MLP market which should not have been impacted are mid-stream MLPs including non-regulated pipelines, and MLPs which do natural gas processing, NGLs fractionation, and fuel terminaling and storage - all of which are not regulated by FERC, but most of which sold off on the news.
Valuations
We believe the biggest factor driving future returns is valuation, and as of Friday, the index was trading at an 8% discount to the S&P 500 on the basis of price-to-projected funds-from-operations over the following year*. The last two occasions that saw a similar discount (November 2008 and February 2016) preceded rallies of 50% and 60% respectively over the following six months.
We believe this latest news is a classic case of "throwing the baby out with the bathwater." And it reminds us that research and in-depth sector and security specific knowledge is critical to long term investment success.
*according to data analytics firm FactSet.
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Equities declined again last week as trade worries continued to weigh down investor sentiment. Investors feared that the proposed tariffs on steel and aluminum would lead to retaliation from major trading partners. And, the dismissal of Rex Tillerson as Secretary of State, a known free-market advocate, was also unsettling for markets. Stocks staged a rally on Friday but it was not enough erase earlier losses in the week.
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> Fed Funds Rate:
Today, Fed Chairman Jerome Powell finished chairing his first Federal Open Market Committee meeting. He announced a rate increase 0.25% (which was expected), made a policy statement, provided updated economic forecasts and held his first press conference. Investors will be carefully combing through his remarks and reports trying to decipher what the Fed's future moves might be.
> Yield Curve:
Plotting the yields of various maturity bonds generates the "yield curve" as shown below. A flat curve occurs when shorter maturities are closer in yield to longer ones, causing little incentive for investors to buy longer-maturity bonds. As the chart shows, in addition to yields moving significantly higher since mid-2016, the Treasury yield curve has flattened meaningfully as well.
> Housing Starts:
Last week we learned that home sales turned noticeably lower in January, as did housing starts and permits in February. Housing starts fell 7% percent in the month while building permits fell 5.7%, much lower than expected.
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World's First 3D Printed House
A charity named New Story has partnered with robotics construction company Icon, to unveil what is believed to be the first 3D-printed house that is fully up to code and permitted for people to inhabit.
The structure, which was unveiled at South By Southwest, was built in less than one day.
The two companies plan to take this proof-of-concept and start producing small houses for families in countries like Haiti and El Salvador. The 800-sq-ft house cost around $10,000 to build using Icon's proprietary Vulcan printer, but the company plans to eventually bring that price down to around $4,000.
The concrete walls are laid in 100 roughly one-inch-thick strands that hold their shape as they harden. After the walls are "printed," New Story crew members come in and install windows, a wooden roof, basic plumbing, and electrical wiring which can be drilled right into the walls. The entire setup, including the finishing, takes under a day.
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New Market Wealth Management offers modern investment solutions backed by extensive research and experience serving the needs of wealthy families. Through our strategic partnership with
Cliffwater LLC
, we have access to institutional-quality research, investment due diligence and asset allocation tools. We believe this level of experience and unique access to in-depth, sophisticated research are essential for success in today's complex world markets.
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