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Summary

  • Kinder Morgan Energy Partners' distribution yield accounts for 70% or more of returns that investors can reasonably expect from equities in the long-run.
  • Kinder Morgan Energy Partners investment valuable in times of market volatility.
  • Pipeline company gives extraordinary exposure to business and distribution growth.

Kinder Morgan Energy Partners (NYSE:KMP) is an ongoing growth opportunity for income investors. Its attractiveness as an investment largely depends on its dominant industry position, a large, diversified asset footprint and a high distribution yield. Of course, other factors are relevant as well such as the tailwinds coming from a booming energy industry, economies of scale and strong management execution skills.

I think the discussion about high-yield income vehicles such as Master Limited Partnerships in general and Kinder Morgan Energy Partners in particular, often neglects the importance of the cash flow yield as part of total returns. Total returns, as measured by professionals, consists both of capital gains and the cash flow yield (that is, regular cash payments to shareholders/unitholders).

Investors who bought into stocks at the end of the 1990s have made literally no money over the following decade. The powerful burst of the dotcom tech bubble, where hamburger joints with an internet connection fetched multi-million dollar valuations, and the collapse of the housing market in the United States in 2007 have left a nasty mark on investors' overall performance results. However, investors who allocated some of their funds to income investments with a consistent dividend record at least got their cash flow yield. Of course, investors were also likely to sit on substantial book losses after the markets crashed, but long-term investors really need not care too much about short-term market volatility (see here why it is better to be long-term minded investor rather than being an investor who is obsessed with short-term quarterly results).

I think this is an extremely valuable observation for investors who want or need to accentuate income. While many investors achieved almost flat returns in the last decade, income investors could rely on some form of income to meet expenses and liabilities. I also like to extend this argument and illustrate the importance of recurring income in the context of long-term equity returns.

Everybody who studied Asset Pricing Models and Portfolio Theory at some point will know that investors can reasonably expect a long-term average return depending on the asset class the investor chooses. A lot of studies have been conducted to determine what kind of long-term equity return investors could achieve - considering they hold a somewhat diversified portfolio.

Depending on the chosen time period and methodology of calculating returns, different studies reveal a long-term return of approximately 9-10% for equities. John P. Hussmann of Hussmann Funds wrote about the long-term return on stocks (readers should keep in mind that the research was published in 1998, but it is as timely as ever):

One of the interesting aspects of the recent bull market is that the historical return earned from holding stocks has increased from the former average of about 10%, to a higher level near 11.5%. The financial community has not missed a beat. If you ask a typical analyst "how much can I expect to earn if I buy stocks and hold them over the long run", the answer of choice is now 11.5%. We'll tell you flatly. The correct answer is something less than 7.4%. Probably much less.

Here's why. The long-term return on a security breaks into two pieces: income from dividends or interest payments, and capital gains from price changes. Notice also that given any future stream of dividend, interest or face value payments, the higher the price you pay now, the lower the annual rate of return you will earn over the long run. In other words, when the future long-term return on a security falls, the current price rises.

Historically, earnings, dividends, revenues, book values and other stock market fundamentals have grown at a rate of 6% annually. Earnings are the most volatile of these, sometimes growing from trough-to-peak at rates approaching 20% annually, and sometimes plunging from peak-to- trough at rates approaching -20% annually. In fact, historically, earnings have been even more volatile than prices themselves. When measured from peak-to-peak or trough-to-trough however, earnings show exactly the same sturdy 6% annual growth rate that other stock market fundamentals exhibit. Over the past century, the highest growth rates over any 30-year period were 6.3% annually for dividends, and 7.8% for earnings (trough to peak).

Historically, the dividend yield on stocks has averaged about 4%, and has fluctuated both above and below this 4% figure. As a result, the historical average return on stocks has typically been 6% + 4% = 10%. That's precisely where that 10% "historical return" on stocks comes from.

(Source: Hussmann Funds)

Other studies conclude that the long-term return on equities is somewhere in the region of 8-9% depending on how the equity risk premium is measured.

In any case, let's assume that investors can reasonably expect a long-run return of 9-10% for stocks per year on average and let's keep in mind that the majority of investors with capital gains focused portfolios didn't make any real money, on average, in the last decade.

Kinder Morgan Energy Partners, which is the cornerstone investment in my income portfolio, currently provides investors with a distribution yield of 7%. Or viewed from another angle: Kinder Morgan Energy Partners provides investors with a cash flow yield equal to approximately 70%-78% of what investors can reasonably expect to make every year, on average, by investing in equity securities (that is, the 9-10% mentioned above). I think this proportion highlights how fundamentally attractive income vehicles are - this, of course, goes especially in times of extraordinary stock market volatility or Bear markets.

Volatility, on the other hand, can provide investors with extraordinary bargains and a large increase in the available opportunity set. Kinder Morgan Energy Partners just recently consolidated forcefully after Barron's published a bearish piece about Kinder Morgan's accounting practices and questioned its distribution prospects. Not surprisingly, a solid recovery followed the initial panic selling and Kinder Morgan Energy Partners is now trading close to $80 again (see chart below).

(click to enlarge)

(Source: StockCharts.com)

Conclusion

Kinder Morgan Energy Partners remains a top investment choice for investors who embrace a long-term view and value recurring cash flow. I made the argument about long-term average stock returns because I wanted to highlight that Kinder Morgan Energy Partners can provide investors with a large chunk of total expected returns merely by buying and holding on to the units. With Kinder Morgan Energy Partners' distributions accounting for 70% or more of long-term total stock returns, investors get an extraordinary good deal by adding the energy business to their portfolios. Occasional setbacks in the underlying unit price make, I believe, for extremely attractive buying opportunities with higher entry yields and a larger margin of safety. Long-term BUY.

Source: Kinder Morgan Energy Partners: Do Not, Ever, Underestimate The Distribution Yield