As you can see from the following chart, it has been a rough two weeks for Kinder Morgan Energy Partners (NYSE:KMP). For those who have forgotten, Barron's last week released a very negative report on KMP that suggested units were extremely overpriced thanks to aggressive accounting of distributable cash flow ("DCF"). This report sent some investors heading for the hills and KMP to a 52-week low. As an investor in KMP, it was not an experience I wish to repeat. Having several days to digest what has gone on, I believe there are several lessons that can be learned about KMP and investing in general. As a side note, this analysis also fully applies to Kinder Morgan Management (NYSE:KMR), an LLC that owns KMP units and automatically reinvests dividends.
(Chart from Google Finance)
First, master limited partnerships ("MLP") are especially vulnerable to bear attacks. KMP, like most MLPs, returns all of its cash to unitholders through distributions. As a consequence, investors get a very nice income stream (a 7.26% yield currently). However, as the company retains no cash, it has to fund all growth projects through the issuance of debt and equity. KMP does this through ATM (at the market) sales and secondary offerings. In fact, KMP sold 6.9 million units the week before Barron's released its article (details available here). This year, KMP will issue about $1.8 billion in equity ($1.1 billion of that in secondaries and the ATM). All financial and operating data can be found here. This increase in supply puts near-term pressure on prices, as you learned in Econ 101. If negative news comes out around the same time as a major issuance, the drop can be exacerbated. Because of this, it is easier to launch a bear attack on an MLP than a traditional company that retains earnings and could even buy back stock on a bad day to minimize the fall.
Second, it is increasingly clear that "all the bad news is priced in" is likely a myth. The negatives in the Barron's piece (which I explained in detail here) are nothing new. In fact, the arguments that KMP understates its maintenance cap-ex, pays too much to its general partner, and has problems at the CO2 unit were all brought up last fall by Hedgeye's Kevin Kaiser. Under the efficient markets theory, only new news should move prices. In this case, KMP was slammed by the same negative commentary, only from a different outlet. Perhaps, some investors who saw no merit in Mr. Kaiser's points totally reversed their opinion because another outlet agreed with him, though that seems foolhardy. If you invest based solely on another's opinion, you should have that person manage your money. It is clear that regurgitated news can impact stocks, and you can never know if the bad news is priced in.
Third, long-term investors should recognize that they are buying a piece (in my case, a very small piece) of a business when buying stocks. Investors therefore should be far more concerned with the performance of the business than the day-to-day fluctuations of the market. Stocks frequently move more than 1% every day, but do values of business really change that much and that frequently? Warren Buffet explains this point brilliantly in his most recent annual letter:
There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings - and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his - and those prices varied widely over short periods of time depending on his mental state - how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits - and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of "Don't just sit there, do something." For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.
A "flash crash" or some other extreme market fluctuation can't hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.
Buffett, like usual, makes a great point here. As long as the business fundamentals are strong, there is no reason to sell a stock. In fact, investors can use irrationally low prices to buy more and generate stronger long-run returns. Does the Barron's article impact how much cash flow Kinder Morgan Energy Partners is generating? Obviously not, so there is no reason to sell on the drop. If anything, investors should use the dip as a buying opportunity.
In this sense, investors should almost be happy units have fallen without any new news. Investors can now buy into a company at 5% less than they could two weeks ago despite no change in fundamentals. If you are bullish and have room to add to a position, this could be a good time to add. Personally, I did consider adding to my position, but KMP is already one of my larger holdings, so I will likely hold to my current position. If you face a cash crunch, a low price is a bad thing. If you are still saving and adding to your portfolio, the best time to do is buy when shares are low. Barron's has done you a favor, as KMP is now on sale.
Finally, the upcoming quarter to be reported mid-April is now even more important. The best way to combat negative sentiment is through strong operating results. Weak results will give the bears more ammunition, while strong numbers should put a bid under the stock. Additionally, management can once again address these concerns on the conference call. This negative attack came mid-quarter when there is a lack of real news, making investor sentiment a bit easier to sway. Financial results are always important, but they are even more important when there has been a swell of negative analysis. I will be looking to these results as an opportunity for KMP to win back some momentum.
Overall, losing money (even if it is only on paper) is never an enjoyable experience. Investors should use opportunities to reflect on what can be learned to minimize losses in the future. There are essentially five major lessons. MLPs are more vulnerable to bear attacks because they issue equity frequently. The bad news is not necessarily priced in, even when it is well-known. Third, long-term investors should not act based on day-to-day price fluctuations, and instead focus on the performance of the underlying business. Fourth, irrational sell-offs can be a good thing, as investors have an opportunity to buy in at an attractive price. Last, the best way to combat negative reports is through strong financial performance, making the upcoming quarter even more important. If like me, you see no issue with KMP's accounting, the best strategy is to stay long and enjoy the 7.3% distribution.