With the US stock market's relentless advance since the March 2009 lows, many of the most astute fund managers, such as Jeremy Grantham, John Hussman, Stanley Druckenmiller, Rob Arnott and Jeff Gundlach, have been warning for quite some time that with valuations currently elevated, long-term equity returns are likely to be disappointing from current price levels. For example, as superstar bond fund manager Jeff Gundlach observed in a recent interview with TheStreet.com, "the complacency regarding stock market risk is very similar today to 1998, 1999 and 2006 and 2007" while John Hussman estimates a long-term nominal return of just 2.9% per annum from current levels. And yet, the beat goes on for the US equity markets, with YTD total returns of nearly 20% for the S&P 500 on the heels of a heady 16% gain in 2012.
For those who are unable or unwilling to sit in cash or take interest rate risk in overpriced Treasuries, this presents a real dilemma, one which is even more pressing than during the last late-cycle period (2005-07) given financial repression, the lack of any appreciable yield at the short end of the yield curve and interest rate risks at the long end. Is the only alternative tactical timing, i.e. jettisoning all investment discipline and taking a "greater fool" approach in the hope that one will outwit millions of other equity market participants in exiting before the inevitable bear market?
I would argue that a useful exercise involves analyzing the performance of various stocks and sectors since the 2007 peak. While it's now widely acknowledged that buying the S&P 500 at 1,576 on October 11, 2007 to "enjoy" (perhaps the wrong term considering the intervening volatility and miniscule returns) annualized returns of roughly 3% was a mistake, it's less well-appreciated that certain equities and even whole sectors have provided splendid returns since that day despite crashing with the markets during the 2008 Global Financial Crisis. What's more, a close look at the outperformers provides clues helpful in identifying where future outperformance is likely to reside.
This in turn suggests that, much like in 2007, aside from risky tactical timing strategies, an investment portfolio concentrated in certain narrow areas is likely the only option at present for providing the high single-digit to double-digit long-term annual returns that most equities investors are seeking. The best candidates at the present time are high-quality mid-stream MLPs (as a sector) and one-off large-cap growth stories with scalable business models, many of them consumer-related, whose growth is not highly dependent on a strong macroeconomic backdrop.
North American Energy Infrastructure - Master Limited Partnerships
Publicly-traded master limited partnership ("MLPs") have become increasingly well-known in recent years, and with the rapid secular increase in North American oil and gas production through the advent of horizontal drilling, they no longer represent an obscure, unnoticed corner of the market. Organized as partnerships rather than as C-corporations, MLPs enjoy pass-through taxation, similar to REITs, provided that at least 90% of their activity falls into various qualifying categories--this significantly lowers their cost of capital which aids in financing capital-intensive infrastructure projects. In practice, the largest and most well-known MLPs, such as Kinder Morgan Energy Partners (KMP) and Enterprise Products Partners (EPD) are engaged in building and operating North America's energy infrastructure--typical asset profiles include pipelines, terminals, natural gas gathering lines and fractionation facilities.
These so-called "midstream" MLPs typically seek to limit their exposure to volatile commodity prices with volume-based fee revenues comprising the lion's share of their earnings and cashflow. Given the capital-intensive nature of the industry and a historical ongoing reliance on capital markets access for growth funding, few operators will commit to new capital projects without adequate long-term offtake or throughput commitments--a prime example would be KMP's recent decision to shelve the proposed Freedom Pipeline project after reluctance by major California refineries to enter into long-term throughput contracts.
Hard assets, often occupying regulated quasi-monopoly positions such as in the case of FERC-regulated interstate pipelines, tied to guaranteed contractual revenues from low-risk customers such as major oil companies render many high-quality mid-stream MLPs very stable businesses. In addition to the appeal of this stability, MLPs have traditionally attracted investors through hefty cash distributions by following the REIT-like practice of paying out nearly all of distributable cashflow each quarter and funding growth capex with the issuance of new partnership units.
As a more recent development, over the past couple of years, several of the higher quality mid-stream operators have evolved toward an accretive growth financing model wherein a portion of cashflow is earmarked for re-investment into growth initiatives rather than distributed to unit holders. The market has responded favorably by valuing such MLPs at higher yield multiples than their brethren.
Of course, stable businesses, generous dividend yields and inflation-protected tangible assets are not the unique preserve of mid-stream MLPs. Utilities, REITs and the consumer staples sector all share similar attributes. And indeed, during the 2013 Q1 parabolic surge in yield-oriented equities, these other sectors actually outperformed MLPs for a brief period before coming back to earth. Nonetheless, the long-term performance of these other sectors since the 2007 peak has been uninspiring (see table below--total returns assuming no re-investment of dividends) while nearly all of the large-cap midstream MLPs have produced annualized returns of between 15% and 25%. What explains this discrepancy?
|Name of Security||Total Return Since 10/11/07||Annualized Return - 10/11/07 - 8/15/13|
|S&P 500 SPDR (SPY)||21.13%||3.33%|
|Utilities Select SPDR (XLU)||14.53%||2.20%|
|Consumer Staples Select SPDR (XLP)||66.79%||9.13%|
|Vanguard REIT Index (VNQ)||13.49%||2.19%|
|Six Largest Holdings in the Alerian MLP Index|
|Enterprise Products Partners||170.47%||18.55%|
|Kinder Morgan Energy Partners||136.52%||15.86%|
|Energy Transfer Partners (ETP)||49.0%||7.06%|
|Plains All-American Partners (PAA)||178.33%||19.13%|
|Magellan Midstream (MMP)||272.01%||25.19%|
|MarkWest Energy Partners (MWE)||251.25%||23.97%|
In a word, secular growth. Much like the epic growth of the information technology and pharmaceuticals sectors during the late 1980s and through the 1990s, North American energy infrastructure is in the throes of a massive secular growth spurt with arguably at least another decade to run. Houston is a boom town with major international law firms opening branch offices as they did in Palo Alto during the 1990s. The local economies of various US states are starting to differentiate themselves based upon whether they are involved in the gas drilling bonanza. A shortage of experienced pipeline engineers, reminiscent of the bidding wars for electrical engineering grads in the 1990s, has already cropped up.
Some estimates suggest that a further US$100 billion to $250 billion of growth capital investment in US energy infrastructure will be required over the coming decade. Despite all of this, and even after a huge multi-year run, the aggregate market capitalization of all MLPs combined is in the vicinity of only a couple hundred billion dollars--roughly the market cap of Chevron (CVX) alone.
The opportunities engendered by this boom are evident through even a cursory comparison of multi-year financial summaries. Across all key financial metrics--revenues, cashflows and operating earnings, even as adjusted on a per share/unit basis--most major MLPs are enjoying a secular growth trajectory that even best-of-breed, large-cap bellwethers in the consumer staples, utilities and REIT sectors can only dream of. Indeed, many of the iconic companies in these other sectors, such as Procter and Gamble (PG), Johnson & Johnson (JNJ) and most utilities have experienced multi-year stagnation across all financial metrics. Unsurprisingly, the relative performance of stock and unit prices across these sectors has reflected the financial trends. Amazingly, mid-stream MLPs have been able to achieve these gangbuster results in the absence of strong US economic growth--this is not a sector that is highly reliant on macroeconomic tailwinds.
Importantly, there is little reason to believe that these trends are likely to be reversed in the foreseeable future. By and large, MLPs have continued to come out every quarter with strong results and rising forecasts while other low-beta, high-yield sectors have largely disappointed and have in many cases engineered EPS growth and dividend growth through rising payout ratios and debt-financed buy-backs.
Consumer Oriented One-off Secular Growth Stories
While the S&P 500 has at long last marginally eclipsed its 2007 closing highs, only a select few companies have provided attractive absolute returns since that date. The strongest performers are listed below:
|Name of Security||Total Return Since 10/11/07||Annualized Return - 10/11/07 - 8/15/13|
|Netflix, Inc. (NFLX)||1,006.11%||50.84%|
|PetSmart, Inc. (PETM)||153.42%||17.24%|
|Chipotle Mexican Grill (CMG)||211.22%||21.43%|
|Buffalo Wild Wings (BWLD)||161.56%||17.87%|
|Walt Disney Company (DIS)||93.0%||11.90%|
|O'Reilly Automotive (ORLY)||263.79%||24.72%|
|Public Storage (PSA)||129.02%||15.23%|
|Union Pacific (UNP)||195.31%||20.35%|
|Whole Foods Market (WFM)||128.54%||15.18%|
|Yum! Brands (YUM)||119.34%||14.38%|
Nearly every name on this list shares two key features. First, with only a couple of exceptions, each company is strongly levered to the US consumer. Despite well-publicized structural issues with US consumer spending--a weak labor market, consumer deleveraging and worsening demographics--each of these companies has grown tremendously over the past six years on the back of US consumer spending. Sectors such as industrials, financials, commodities and business services are poorly represented on the list if not absent entirely.
Second, nearly all of the names on this list occupy market niches that have been in the midst of a secular growth boom for the past several years. MA (and Visa, which missed this list only because it went public in March of 2008) are leveraged to the accelerating use of electronic payments. One-off retail concepts such as SBUX, WFM, PETM, ORLY, CMG and BWLD have carved out their own market niches with store expansions fueling explosive growth. Companies such as DIS, AAPL and NKE have continued to leverage unique intellectual property portfolios and brands into steady growth through good times and bad. Similarly, growth has continued unabated for disruptive, internet-based, consumer-facing businesses such as PCLN, NFLX and AMZN.
Importantly, for most names, the growth spurt pre-dates 2007. In other words, it's not as though positive black swan growth catalysts emerged phoenix-like out of the ashes of 2008 to power outperformance. Each business was outgrowing the broad market well before the Global Financial Crisis. Moreover, as with mid-stream MLPs, the secular trends driving this growth overpowered the structural headwinds that have conspired to hold back the broader economy and most other companies.
Lessons from 2007 - What's in the Cafeteria?
As PIMCO's Bill Gross often says, "you can only eat what's in the cafeteria [i.e. invest only where there's value at any particular juncture]". According to a wide variety of dependable valuation measures, as in 2006 and 2007, attractive market pickings are currently very slim. Where are investors to dine in the cafeteria after this year's 20% run? Can the October 2007 playbook provide helpful guidance?
2013 is not 2007, and there can be no guarantee that the large-cap growth darlings that we all wish we had bought and put away in 2007 will not stumble going forward, with or without a broader bear market. Also, it's likely that if we were to draw up a new table of outperformers five years from now, many of the names will be different--it's even possible that some of the names on this list are currently benefitting from unsustainable bubble valuations. Still, secular growth at a reasonable price, while research-intensive and tricky to implement, has invariably proven to be a winning formula over the decades with consumer-oriented names usually offering the best potential.
Similarly, no one knows what the future holds for mid-stream MLPs--legislative tax changes, excessive capital flowing into the sector driving down returns, FERC regulatory changes and environmental incidents all stand out as potential risks. However, valuation multiples in the sector are not significantly higher than they were at the 2007 peak, and despite a recent bout of weak natural gas liquid (NGL) prices, neither fundamentals nor prospects appear to be impaired or deteriorating in any material way.
Accordingly, there is reason to believe that a portfolio comprised of strong mid-stream MLPs and consumer-oriented secular growth stories stands an excellent chance of dramatically outperforming the market and most other equity portfolios as well as providing strong absolute returns. Every cycle is different, and it's certainly possible that other narrow sectors which were unattractive at the 2007 peak, such as bombed out commodity producers, may also offer strong long-term returns from current levels. Perhaps natural gas producers and gold miners are now on the menu as well! Nonetheless, analyzing the characteristics of what has worked since the last pre-crash peak may be useful in constructing a concentrated portfolio offering long-term returns that are otherwise unavailable at this juncture.