A previous article discussed the concept of picking stocks by evaluating macroeconomic trends. One such trend is the low and falling level of interest rates. While interest rates have been falling for 30 years, the Federal Reserve has also pledged to do everything it can to make us feel wealthier by lowering the time-value of money. I will avoid editorializing about the wisdom of this strategy, rather it should be noted as an investment thesis that falling interest rates increase investor demand for income producing assets. One such asset is a master limited partnership (MLP). Buying an asset likely to receive increased investor demand should provide alpha. One of the best plays in this space is Kinder Morgan Energy Partners (NYSE:KMP). As the trend of falling interest rates shows no sign of slowing and the distributions from this limited partnership have increased steadily, it is expected that Kinder Morgan will outperform in 2013, especially due to its recent pullback.
Kinder Morgan is a combination of playing a trend in lowering interest rates and the boom in natural gas distribution, neither of which is expected to end any time in the near future. The MLP is relatively detached from commodity prices and instead operates as a toll road, collecting money that can be paid back to investors in exchange for the use of its pipelines. It is probably one of the most boring businesses that you can imagine and over the last 10 years, this has led to marvelous capital gains and dividend income. Kinder Morgan Energy Partners transports oil liquids, natural gas, carbon dioxide, manages rail terminals and material handling facilities (21.9%, 29.5% and 24.4% of revenues, respectively in addition to some miscellaneous revenues from its Canada segment).
Another factor making the current sell-off a strong buying opportunity is the preferable tax status of MLPs. Unlike dividend paying stocks, MLPs pay dividends and are taxed by reducing your cost basis. Thus, until you sell, or until you have received more in distributions than you paid for the stock, you do not have to pay the tax man. This tax advantage could make MLPs more desirable compared to dividend paying stocks if the tax on dividends increases above the tax on long-term capital gains. It also allows you to compound your investment prior to paying taxes.
The figure below illustrates how buying opportunities in Kinder Morgan are evident from the spread between a BAA corporate bond yield and the dividend yield of the stock. In other words, each time the dividend yield of Kinder Morgan (in yellow) spikes above the yield of a BAA corporate bond (in green), it is a timely signal to buy the stock. In the summer of 2011, the spread hit a maximum of 1.3%. The spread is currently 1.6%, as corporate bonds have rallied tremendously. It is expected that the stock will rally back toward its average spread from a BAA bond. With the current rate at 4.57% it is essential to realize that assets such as Kinder Morgan have become and are becoming more valuable. Kinder Morgan Energy Partners is probably not dirt cheap, Valuentum estimated its per share value at $93/share, while Standard and Poor's rates the fair value at $70/share (S&P seems to consistently value MLPs and REITs very conservatively). However, while the stock may not be dirt cheap, it is expected to receive considerable demand for the income that it can produce.
Previously. buying opportunities according to this method of analysis occurred during mid-2006, early-2009 and mid-2011. Each time, this spread has increased during a sell-off, the subsequent 12 months saw a rally in excess of 20%. While past performance is never a guarantee of future results, this drop is expected to be yet another such buying opportunity.
Interestingly, the chart below shows significant resemblance to the sell-off in Kinder Morgan Energy Partners during the summer of 2011. The stock is once again descending and a buy with the RSI below 40, hopefully around the range of the lower Bollinger Band (shown in green at ~$76/share), should prove to be a strong entry point. Expect some volatile price action, however, the entry point ensures a 6.6% yield at cost or a nearly 7% yield based on the 6% increase in distribution that was just announced by Kinder Morgan Energy Partners.
Interest rates are zero bound for the foreseeable future, and bond yields keep going lower. This makes a future rally in Kinder Morgan Energy Partners as near to a sure thing as there is in the stock market. Once the volatility has faded, investors will remember that the stock's dividend yield is greater than the yield they can get from a corporate bond, and much greater than they can expect from a Treasury note. It is therefore proposed that the current valuation of Kinder Morgan Energy Partners is not a value trap.
Additional disclosure: The article above should not be considered a solicitation to buy the mentioned security. Please conduct your own due diligence or speak to a financial advisor before taking a long position in any stock.