The fourth quarter of 2011 was a good time to own master limited partnerships.
The Alerian MLP Index touched an intra-day low of barely 316 on Oct. 4, 2011, and proceeded to rally hard, closing the year at nearly 390. Fourth-quarter returns for the index were nearly 20 percent.
MLPs benefited from a market-wide rally last year in pretty much everything this side of U.S. Treasury bonds, as it became clear that a US government debt downgrade wouldn't run the world economy off a cliff. But the sector also had a solid fourth quarter in calendar 2009 and 2010, as did most dividend-paying stocks.
Looking further back, MLPs also tore up the track in the fourth quarter of 2006, with the Alerian MLP Index soaring from barely 250 to over 280 by the end of the year. They scored upper-single-digit returns in 2007. And even in 2008, when almost nothing in the equity markets held its ground, MLPs were among the first sectors to recover, staging a 15 percent-plus rally from a late November bottom through the end of that troubled year.
MLPs have also been outperformers for the whole period since stocks bottomed in early 2009. Fourth quarters, however, have been special for a couple of reasons, mainly MLPs' superior yields and the reliability of their cash flows.
For the large institutions that dominate global trading, the end of the calendar year means one of two things. If a manager or team has been particularly successful, they'll look to lock in or at least safeguard some of those returns by moving to higher percentage areas of the market. MLPs' generous and rising yields guarantee they'll be making something even if the overall market is flat, so they definitely fit the bill.
If the year has been less than stellar for a manager and his or her team, they may try to place some big bets to get back on track. Even if they do that, however, they're also likely to focus on safety and yield to some extent to improve the overall quality of their portfolios, and MLPs are again an ideal vehicle.
All that is essentially moot for individual investors like us. Come Jan. 7, we won't care what our portfolios looked like Dec. 31. We just want our picks to be worth more as businesses, so they can ramp up their distributions to us.
For institutional money managers, however, beating benchmarks and set dates are the game. And with MLPs increasingly owned by institutions, we can expect near-term trading to reflect their needs.
So what does that mean for us as we enter the fourth quarter of 2012?
First, barring major surprises in the third-quarter results due out over the next five to six weeks we can expect more buying of MLPs by institutions, and very likely higher prices. That means we need to be careful with prices paid for any new purchases of MLPs we make going forward, to ensure we don't overpay.
Second, it's likely the MLPs with the most institutional ownership will be more volatile than those with less institutional ownership. Again, that's assuming there are no significant events at underlying businesses to change value.
All else equal, a large general partner interest in the common units will stabilize an MLP's price. It's a vote of confidence in the business plan and distribution growth track of the LP, just as insider buying is, as it conjoins the interests of the GP and the limited partners. And it's a good sign that the parent will be dropping down assets to the LP, providing the fuel for further distribution increases.
On the other side of the equation are the IDRs, which range from partnership to partnership. My view is the lower the fees paid to the general partner the better, but with two caveats.
First, you get what you pay for in management. And while it may be irksome to see the GP getting a bigger piece of the pie than others do, the only really important thing for us investors is the bottom line. If the LP is producing big yields and distribution growth, it's likely worth shelling out an above-average fee to management.
Second, MLPs with higher IDRs often trade at discounts to that are well out of proportion to the additional fees. Enterprise Products Partners LP (NYSE:EPD), Kinder Morgan Energy Partners and Magellan Midstream Partners LP (NYSE:MMP), for example, are arguably of equally high quality. Enterprise Products and Magellan Midstream arguably give more back to limited partners because they have no GPs or IDRs, while Kinder Morgan Energy Partners is frequently cited by sector critics for having above-average IDRs.
On the other hand, Magellan Midstream yields just 4.3 percent and Enterprise Products yields 4.9 percent, while Kinder Morgan Energy Partners pays out 6 percent. And the latter's annual dividend growth rate of 7 percent is actually considerably faster than Enterprise Products' 5 percent.
The upshot is IDRs are just one consideration when it comes to picking MLPs for your portfolio. And they're far less important than the support a good GP can provide for an MLP's long-run cash flow and distribution growth.
What happens if there's an overall market correction? Odds are MLPs with more institutional ownership and less general partner involvement will see their prices most affected.
Stock market selloffs come with the territory, no matter what you're invested in. And as investors interested in yield, it's equally inevitable that we're going to be holding MLPs when such negative events occur.
The key, however, isn't to change your investment strategy to avoid every downturn. It's making sure what you own will recover its value when conditions inevitably improve. And as we saw in March 2009, they always do, no matter how bad things may get at times.
That means staying focused on the health of underlying businesses. So long as what we own is strong inside and ready to keep growing distributions, we're going to hold on, no matter how choppy conditions get. Conversely, if a company's fortunes fade we'll be out and onto something else. I explain the details of MLP investing and offer up several picks in my report, MLP Investments Revealed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.