The Temptation To Chase Past Performance

by: James A. Kostohryz
One would think that the notion that past performance does not guarantee future results would have been sufficiently drilled into people’s heads that it would require no explanation. Yet human nature is such that people make foolish decisions over and over despite repeated warnings.
Evidently people need to repeatedly hear: “don’t drink and drive,” “use a condom” and “just say no drugs.”
Why? I think it is in part because when a behavior is tempting, people will find all sorts of excuses to justify the proscribed behavior.
Such is the case with performance chasing. Greed is an impulse which is right up there with destructive behaviors that perpetrators know they shouldn’t engage in. Chasing performance in the search for profit is a bit like taking drugs: People know they should not do it, and yet they find all sorts of reasons to convince themselves why it will not be harmful to them this time.
The purpose of this article is to remind people that chasing past performance is not wise. In this article will frequently mention MLPs. I have chosen this example since I continually hear statements in my comment threads extolling ownership of MLPs on the grounds that they have performed magnificently in the past.
So let me make one thing clear from the outset: The goal of this article is not to prove that MLPs will underperform in the future. The goal of this article is merely to use the example of MLPs to illustrate the fact that excellent performance of a sector or stock in the past is not a persuasive reason to expect continued outperformance in the future.
MLP Performance Chasing
In my most recent article entitled “Income Traps To Be Avoided,” I made a very brief reference to MLPs as a sector that I believe is likely to underperform in the next decade. Unfortunately, every time that I even hint that MLPs might underperform in the next few years I am barraged with reactionary and frequently insulting commentary by a few rabid fans of this sector. Many of these folks seem to get more riled up than if I had insulted their mother. Heaven forbid that anybody suggest that MLPs such as Enbridge Energy Partners (NYSE:EEP), Encore Energy (NYSE:ENP), El Paso Pipeline Partners (NYSE:EPB), EV Energy Partners (NASDAQ:EVEP), Kinder Morgan Energy Partners (NYSE:KMP), Kinder Morgan Management (KMR and Oneok Partners (NYSE:OKS) may not perform as well in the next 15 years as they have for the last 15.
By far, the most frequent argument I get from MLP fans that angrily deny that the sector may underperform is that MLPs have performed wonderfully since 1995.
So let’s get this straight: MLPs have indeed performed wonderfully. Since 1995, the Alerian Index has risen more than three-fold. And if distributions had been faithfully reinvested, the value of an initial investment would have risen by a factor of about 10. This is a marvelous performance indeed.
There is just one problem. The past performance of MLPs is irrelevant to the projection of future returns for investors in the sector. I repeat, the statistics regarding past total returns are completely and utterly irrelevant.
To many this will seem obvious. But it is clearly not obvious enough to many others.
Reasons Why Performance Chasing Is Not Wise
If successful investing were merely a matter of picking the best performing stocks and/or sectors for the past 15 years and investing in those, then getting rich would be easy. Unfortunately, it is not easy.
Chasing performance – whether it be MLP or any other stocks or sectors -- does not work for many reasons. I will describe only two of these reasons here.
  1. Good performance tends to lead to performance chasing, which in turn tends to lead to overvaluation.
  2. Macroeconomic and sectorial factors that lead to outperformance tend to be cyclical.

Performance Chasing And Valuation

Investors chase performance. There is no doubt about this. The question is whether chasing performance leads to superior investment results.

Actually, according to numerous studies, a kind of performance chasing referred to as “momentum” seems to produce excess returns. However, momentum strategies tend to work over relatively short-term time frames. All studies show that the advantages of momentum do not persist over time.

Why doesn’t the principle of momentum work over long periods of time? One reason is clear: Outperformance over time will tend to result in overvaluation. Thus, an important reason that performance chasing does not work is that it is self-defeating.

Performance chasing is intimately linked to overvaluation – relative and/or absolute. At the same time, overvaluation of stocks and sectors based on valuation multiples such as P/BV, PE, P/CF and EV/EBITDA (relative to their return on capital and growth prospects) will tend to lead to underperformance over time.

Why? Even if earnings, cash flow and distributions grow at expected rates, the relation of price to these variables will tend to decline in both relative and absolute terms to “normal” and even below “normal” levels over time, depending on prevailing economic and financial conditions.

Thus, multiple contraction will tend to drive underperformance over time, even if earnings, cash flow and distribution projections are met. Take the example of a company such as Microsoft (NASDAQ:MSFT) in the late 1990s. Since the late 1990s, MSFT has grown earnings and cash flow tremendously. Yet, the stock price of MSFT has gone nowhere in well over a decade.

As I will explain later on, it is my view that MLPs are in a position not dissimilar to that of Microsoft a decade ago – even if MLPs generate good income and cash flow, overall total returns are likely to be disappointing due to their high valuations.

Cyclicality Of Sectorial And Macroeconomic Fundamentals

Another reason that performance chasing does not work is that there is a tendency for fundamentals to work in cycles. Companies and sectors that have done very well for a long time frequently underperform in a subsequent period because the fundamental factors at a macro and/or sectorial level that drove outperformance in a prior period will tend reverse in a subsequent period.

For example, macroeconomically, microeconomically and financially, for reasons I have alluded to in previous articles, it is quite likely that that conditions will not be as favorable for MLPs in the next 15 years as they have been for the past 15. Let us review just a few of these reasons briefly.
  1. Interest rate environment radically different. The MLP business model depends greatly on the availability of low long-term interest rates. MLPs have benefited greatly from large and steady reductions in long-term interest rates for the past 15 years. Those idyllic days are almost over. Long-term interest rates simply cannot go substantially any lower than they are right now. Indeed, for reasons explained here, an era of higher long-term interest rates is almost certainly ahead.
  2. Capital markets environment radically different. Because MLPs distribute virtually all of their available cash flow to shareholders in the form of distributions, MLPs depend fundamentally for their growth on easy access to capital markets to raise equity and debt. In this regard, it is important to bear in mind that MLPs have benefited greatly from the extraordinary financial market conditions that prevailed during the Great Moderation (1985-2008). Unfortunately, those days are over. Times of greater macroeconomic turbulence have arrived and can be expected ahead. This implies that MLPs will find that it will be more difficult and more expensive to obtain long-term financing.
  3. Valuations and popularity radically different. For reasons that I explain below, MLPs were an out-of-favor and relatively undervalued sector 15 years ago. Today they are a popular and relatively overvalued sector. Relative valuations clearly do not favor the sector’s performance going forward.
  4. Competition radically different. MLPs had little intra-industry competition 15 years ago. Today the proliferation of MLPs has caused the cost of assets and expenses in the sector to be bid up, to the detriment of MLP shareholder returns.
There are a host of other reasons why I do not favor MLPs today and I will expand on those issues at another time. For now, the four factors cited above should be more than enough to demonstrate that the next 15 years will not be substantially like the past 15 – simply because conditions are different.
It might be argued that even if conditions are not as good as they were in the past 15 years, they might be good enough to allow MLPs to continue to outperform, albeit at a more modest pace in the next 15. Perhaps; perhaps not.
One thing is for sure. Looking at past performance is not going to give us the answer to that question. Why? Conditions today are fundamentally different than they were 15 years ago.
It might be argued that those conditions might be the same, better or worse. What is absolutely clear is that the conditions are not the same. Therefore, past performance achieved in the midst of different conditions is not relevant.
The Contradiction Inherent In Performance Chasing
There is a contradiction at the hear of performance chasing. Take the example of MLPs. It is an ironic fact that people that make their investment decisions based on past performance would never – and I mean never -- have invested in MLPs in 1995. That is another reason why citing statistics regarding MLP outperformance in the past 15 years is completely spurious and contradictory.
In 1995, the entire oil and gas industry had been performing miserably and had been destroying shareholder value for the better part of 15 years. I was an oil and gas analyst during the 1990s, and I remember those times very well.
Investors generally wanted nothing to do with oil and gas related stocks at that time – much less capital-intensive utility-type companies tied to this sector. These stocks were the dregs. Indeed, folks generally wanted nothing to do with capital-intensive industries linked to commodities. It became a widely accepted dogma that it was impossible to make money investing in commodity-oriented sectors.
The late 1990s was the age of the “new economy.” People at that time were enamored with technology, telecom, media, intellectual property and biotech. Hard assets were out; intangible assets such as intellectual property, brands and distribution of information in the “information age” were in. Stocks in those sectors had been the winners of the decade before. Thus, everybody piled into those stocks - particularly, the most naïve individuals. As a result, valuations in relation to book value, earnings and cash flow became heady. Thus, even though companies such as Intel (NASDAQ:INTC), (NASDAQ:AMGN), Microsoft, Time-Warner (NYSE:TWX), Coca-Cola (NYSE:KO) and Disney (NYSE:DIS) have been growing earnings and cash flow very successfully since the late 1990s, their stock prices have gone nowhere for well over a decade.
Furthermore, the consensus at that time was that dividends and dividend stocks were a waste of money and time. At that time, dividends were anathema. They were regarded as a tax inefficient use of capital. At that time, it was all about reinvestment, M&A or buybacks. Dividends stocks were the dregs.
For that reason, MLPs at that time were in an asset class that was about as unpopular as they get.
For that reason, nobody that is investing in those stocks today based on their past performance would have invested in those stocks at that time. Yet, ironically, a decade ago was precisely the time to get involved with the oil and gas industry, when the stocks were cheap and the macro and micro fundamentals were about to turn.
And if anybody replies that the fundamentals of MLPs today are better today than they were for the popular sectors in the mid 90s, I would submit that those people were not really around in the mid 90s or that they have bad memories. The narratives that were built for the go-go sectors in the late 1990s were practically air-tight. These were “can’t miss” stocks, just like MLPs are touted to be today. Individual investors fell hook, line and sinker.
Self-Justification And Bubble Formation
What I find very eerie in the MLP space is the crazy talk among fans to the effect that traditional valuation metrics applied to C-Corps “are not relevant” to MLPs. These folks will talk with great assurance regarding why traditional valuation metrics such as PE or P/BV are not relevant to MLPs. Furthermore, they will say that dividend coverage ratio based on net earnings is not relevant.
Just strip out depreciation or replacement costs, they say. No matter that it is a hugely capital-intensive industry. We will just pretend that these assets can perpetuate themselves into eternity with mere "maintenance capex" so that only a metric called "DCF" is relevant to measuring profitability.
This rhetoric is so like the 90s propaganda for the hot sectors such as biotech, telecom, media and Internet that it is not even funny.
PE is relevant to MLPs. Depreciation is relevant to capital-intensive sectors because assets have to be replaced (even if it is over a longer period of time than the depreciation schedule). Dividend coverage ratios based on earnings is relevant. P/CF is relevant. P/CF is relevant. ROE is relevant. I will demonstrate all of this definitively in the future. For now, let me just warn investors that are willing to listen: Ignore all of this hype about how traditional valuation metrics do not apply to MLPs. This is bubble talk.
All of the traditional valuation metrics apply to MLPs – to greater and lesser degrees. This is just the same as for C-Corps. For example, many C-Corps also have depreciation schedules that are faster than the useful life of their operating assets. No valuation metric is definitive for C-Corps (any more than they are for MLPs) and all of these metrics have varying utility when applied to C-Corps. There is nothing particularly unique about MLPs in this regard.
The hype about how MLPs are a “special case” that defies gravity is just a justification for performance chasing and paying high valuations for stocks in a hot sector. It’s a situation that is no different from what was going on in the mid and early 90s with telecom, media, tech and biotech stocks when it was claimed that traditional valuation metrics did not apply to them.
I am writing this article because I believe that many investors are often lured into investing into a sector based on juicy income distributions combined with inappropriate and faulty reasoning. When people keep telling me that they are invested in MLPs because the have risen 10 times in the past 15 years, it is truly telling. When they tell me that it is OK to overpay for these stocks based on their valuations of earnings and cash flow because they are “special cases” it even more telling.
Just like in all ages, investors tend to chase performance. People want to be rich, so they will invest in the things that would have made them rich if they had invested in them in the past. Furthermore, even though folks know at an intellectual level that they should not do this, they develop all sorts of fancy narratives to justify their performance chasing and associated overvaluation.
Greed is eternal. Human nature never changes.
Fortunately, civilized people have the wherewithal to resist these primal urges.
Let me be clear: In this article I have not proved that MLPs will underperform in the future. That was not my goal. My goal is merely to make it clear that the fact that MLPs have outperformed in the past is no reason to think that they will continue to do so in the future. Quite to the contrary, there are very important reasons to think that MLP’s will underperform in the future – in part for reasons that are ironically tied to their outperformance in the past: Valuation and cyclicality.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.