Although it may seem counterintuitive, most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain substantial. An attractive niche should be characterized by customer captivity, small size relative to the level of fixed costs and the absence of vigilant dominant competitors. In fact, companies can build quasi-monopolies in markets that are only large enough to support one company profitably, because it makes no economic sense for a new entrant to spend the necessary capital to enter the markets.

Infrastructure firms provide an extraordinary example of niche domination. MLPs have high barriers to entry due to capital requirements and geographical monopolies. A business in the midstream is a toll collector that takes products from one point to another. Many have monopolistic characteristics as building a pipeline requires clearing multiple regulatory hurdles which can be challenging to overcome given ongoing environmental concerns. Furthermore, when there is not enough demand between two points to profitably support multiple pipelines, a single pipeline enjoys niche economics and can charge the maximum allowable rates. Those rates can be quite attractive for owners as pipelines have a somewhat looser regulatory regime than utilities.

A Simple Investment Thesis

Thematically, MLPs represent an investment in the build-out of our domestic energy infrastructure over the next few decades. Nearly all other infrastructure is contingent upon pipelines and other energy assets to provide the lifeblood of our economy. These businesses operate toll-road business models supported by long-life real assets, with inflation hedges built into long-term contracts, regional monopolistic footprints, and relatively inelastic long-term energy demand growth. The resulting operating fundamentals allowed MLPs to generate predictable cash flows and pay consistent and growing quarterly cash distributions over the past few decades, which translate into very attractive investment characteristics: long-term stability and low volatility, attractive risk-adjusted returns, diversification via low correlation with other asset classes, and the potential for an effective inflation hedge.

The two most comparable asset classes to MLPs are Utilities and Real Estate Investment Trusts (REITs). Both Utilities and MLPs benefit from inelastic long-term energy demand growth. However, Utilities are subject to a more local and highly scrutinized regulatory body focused on returning cost savings to their constituents. The interstate pipelines owned by MLPs, on the other hand, are predominantly regulated at the federal level by the Federal Energy Regulatory Commission (FERC), where infrastructure assets are viewed as critical to energy security.

The commercial buildings held inside REITs are viewed as hard assets with inherent tangible value. Similarly, the steel pipelines and storage tanks that transport and store the nation's energy are hard assets with associated permanent value. The useful life of MLP income-producing assets is typically over fifty years. REIT rental income tends to fluctuate with macro-economic conditions and market demand; whereas MLPs benefit from inelastic energy demand and inflation-adjusted tariffs.

Meaningful new infrastructure investment requires capital, and both are needed to efficiently connect growing areas of energy demand with new areas of supply. Pipeline and related infrastructure assets are expected to support growing population centers and facilitate the transportation of natural gas and crude oil across North America, creating a compelling investment opportunity in the coming decades. Growth in the asset class will stem from additional organic projects, asset acquisitions from integrated majors, as well as the monetization of assets held in private hands. According to the Interstate Natural Gas Association of America, over the next two decades, roughly $130 to $210 billion of additional capital expenditures will need to be spent on natural gas infrastructure development to meet growing and shifting energy demands. On the acquisition front, we estimate that at least $200 billion of midstream assets are housed at public and private corporate structures, all of which could eventually be acquired by MLPs. Longer-term, we believe new midstream infrastructure development represents a highly sustainable secular growth story, with MLPs the natural structure to undertake the vast majority of such investment. Put simply, we are likely on the verge of the largest energy infrastructure build-out since World War II.

Tomorrow, we'll review the tax-advantaged cash flow that these businesses generate before we take a look at the current and potential valuation of the asset class.

Disclosure: I am long [[AMLP]]. 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.

Like Tortoise, we believe pipelines offer a high quality and predictable means of gaining exposure to the growing investment in our nation's energy resources. The resilient nature of these real assets, combined with attractive and growing yields, offer a compelling opportunity in an uncertain world where high quality income is difficult to come by. In this series of posts - excerpts from our next Broyhill Letter - we will explore this opportunity in detail, beginning with an introduction to Investing in Infrastructure today:

Investing in Infrastructure

"A successful society is characterized by a rising living standard for its population, increasing investment in factories and basic infrastructure, and the generation of additional surplus, which is invested in generating new discoveries in science and technology."

- Robert Trout, "The Iron Man of Radio"

Oxford Dictionaries defines infrastructure as the basic physical and organizational structures and facilities (e.g. buildings, roads, power supplies) needed for the operation of a society. Broyhill characterizes an investment in the "operation of a society" as a safe bet amidst a hazardous macroeconomic backdrop. Providing access to essential natural resources required to uphold or improve standards of living are among the most fundamental of societal services.

Sources trace the origin of the word "infrastructure" in the English language to 1927, but the military use of the term achieved prevalence after the formation of NATO in the 1940s, and was later adopted by urban planners in its modern sense around the 1970s. The term came to prominence in the United States in the 1980s following the publication of America in Ruins, which kicked off a public-policy discussion around the nation's "infrastructure crisis" - instigated by decades of insufficient investment and inadequate maintenance of public works.

Today, infrastructure may be owned and managed by governments or by private companies, but in the economic context of an extended debt deleveraging, policy makers can no longer resort to the Rooseveltian Recipes reliant on massive borrowing to fund infrastructure projects without regard for the long-term fiscal consequences of such policies. Even so, existing assets must still be maintained and repaired, and new assets must be built to ensure the continued competitiveness of the western world. Given that the required investment is enormous and the traditional provider of that capital - government - does not have the resources to do that anymore, private sector interest has grown considerably in recent years.

According to Preqin, over $175 billion has been raised by banks and managers for private infrastructure funds since 2004 with pension funds the leading investors in the asset class. The OECD estimates that there will be a worldwide need for as much as $30 trillion of infrastructure investment in the next two decades. In other words, there is considerable room for additional capital flows considering that average allocations to the asset class only represent one percent of pension assets today. Interest is growing for obvious reasons - infrastructure is a natural fit for large pensions and sovereign wealth funds with long-term liabilities. These institutional investors need to protect the value of their portfolio from the toxic consequence of currency debasement and inflation, while minimizing volatility in order to maximize the recurrent cash flows to beneficiaries. As a result, infrastructure is an ideal investment that provides tangible advantages: long duration real assets; high and growing distributions with natural inflation hedges; and statistical diversification which reduces overall portfolio volatility.

Enter The Master Limited Partnership

Although long recognized as an attractive asset class for institutional investors, access to infrastructure investment has been historically difficult to achieve for individual investors, particularly in the United States, where the majority of infrastructure is government owned and controlled. Fortunately, a liquid alternative now exists. Domestic energy infrastructure assets are often organized as Master Limited Partnerships, or MLPs, which are listed companies that own, manage and operate qualifying assets. The MLP structure enables these firms to utilize the tax advantages of partnerships. Shares trade like a corporate stock, but only pay one level of federal income tax so they are not subject to the double taxation of public companies.

MLPs provide investors with a direct pathway to infrastructure investment. Traditional MLP assets include intrastate pipeline systems that take products to storage, regulated interstate pipelines that go across state borders, and the gathering and processing systems that take natural resources from the wellhead to the distribution point. These pipelines typically collect steady fees with long-term contracts, regardless of the types of and prices for the commodities that pass through the pipes. Upstream exploration and production MLPs find long-lived oil and gas assets after they have had a drop in production. These assets have a long tail, which means a slow decline in future production and steady cash flow. Downstream MLPs are the refining assets and chemical plants.

(click to enlarge)

By confining 90% of their income to these specific "qualifying" activities, MLP units are able to trade on public securities exchanges without entity level taxation. As of March 31, 2012, there were 81 publicly traded MLPs with two classes of ownership - general partnersand limited partners. GPs manage the partnership's operations, receive incentive distribution rights, and generally maintain a 2% economic stake in the partnership. LPs are not involved in the operations of the partnership and have limited liability, much like the shareholder of a publicly traded corporation.

We'll investigate the competitive dynamics of the industry, in addition to outlining our investment thesis for the industry, tomorrow.

Disclosure: I am long [[AMLP]]. 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.

If you had to choose a handful of letters to hone your value investing skill set, Howard Marks would easily fall near the top of our list.  His most recent piece is no exception.  We’ve attached it in full along with some of our favorite quotes (accompanied by various illustrations) which should prove to be timely as this bull cycle gets progressively longer in the tooth.

High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)

But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.

There’s nothing more risky than a widespread belief that there’s no risk . . . and, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

I recite all of this because I have no doubt that investors are making substantial movement back in the same direction . . . In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason . . . But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions.

In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap.

If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasuries or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.

Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.

Prudent Behavior in a Low-Return World

• Go to cash – not a real alternative for most investors.
• Ignore the lowness of absolute returns and pursue the best relative returns.
• Forget that elevated prices might imply a correction, and buy for the long run.
• Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
• Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.

Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:

• the so-so U.S. recovery;
• the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;
• the economic impact of deleveraging and austerity;
• the over-indebtedness of peripheral eurozone countries;
• the possibility of rekindled inflation and rising interest rates;
• the uncertain outlook for the dollar, euro and sterling; and
• the instability in the Middle East and resulting uncertainty over the price of oil.

With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right.

We have a hard time finding anything to disagree with in Mark’s most recent letter and look forward to reading his most recent book.

How Quickly They Forget 05-25-11

Housing remains the most unaffordable in Australia, except for the single market in China (Hong Kong) included in this Survey. Australia is characterized by more restrictive land use policies. The Organization for Economic Co-operation and Development has recommended that Australia “ease” its housing supply constraints, which have driven up housing prices.

Australia’s major markets have a severely unaffordable Median Multiple of 7.1, nearly 2.4 times the 3.0 affordability standard. Each of the major markets, with the exception of Sydney had housing affordability within the 3.0 norm during the 1980s (Figure 2). Australia’s Median Multiple for all markets was also the highest outside China, at a severely unaffordable 6.1.

Sydney, which has had long-standing limits on housing development on the urban fringe, was the most unaffordable major market. Sydney had a Median Multiple of 9.6. Prices rose strongly in Melbourne, which had a Median Multiple of 9.0. Adelaide had a Median Multiple of 7.1, despite being the lowest demand major market in the nation. Brisbane (6.6) and Perth (6.3) were less unaffordable, but were still well above the threshold of severe unaffordability.

More troubling than price alone, is the conclusion that this house price escalation has occurred generally independent from varying demand levels.  In Sydney and Melbourne, the median priced house now costs a household at least $750,000 more than the historic housing affordability norm, ultimately retarding consumer spending.  Last year’s study showed that the median household would spend over half of its pre-tax income on mortgage payments.  We would note that these payments have only gotten larger with several RBA interest rate hikes since that study was published.  As we pointed out in our initial piece on the Troubles in Oz, the ratio of home prices to income has always fluctuated around a stagnant long term average, because income acts as an anchor limiting the price homeowners are able to pay and has always pulled price back to earth in every instance.

A similar ratio, calculated by the Economist puts the Australian housing market at the top of the charts.  In theory, the price of a home should reflect the value of the services it provides, so the Economist  calculates the ratio of prices to rents in 20 economies.  Using this measuring stick, the Land of Oz is 56% overvalued and inching toward fair value as prices fell 1.6% month over month.  But as Michael Lewis so eloquently described in a recent Vanity Fair article, When Irish Eyes Are Crying:

Real-estate bubbles never end with soft landings.  A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become and flee the market, and the market will crash.  It was the nature of real-estate booms to end with crashes.

Their real-estate boom had the flavor of a family lie: it was sustainable so long as it went unquestioned, and it went unquestioned so long as it appeared sustainable.  After all, once the value of Irish real estate came untethered from rents there was no value for it that couldn’t be justified.

There is an iron law of house prices . . . The more house prices rise relative to income and rents, the more they subsequently fall.

Smart investors in the U.S. looked for a slow-down in the appreciation of home prices as an indication that momentum was waning and price increases were unstable.  Month over month declines also served as early warning sign that the bubble was beginning to deflate at home.  Perhaps we are nearing an inflection point Down Under as well.  Steve Keen, who has followed the Australian real estate market closer than anyone on the street, argues that the government-stimulated debt-driven boost to aggregate demand was the primary reason Australia got through the Great Financial Crisis (GFC) so well, and also why Australian real estate prices avoided anything but a hick-up in an upward trend.  But he shows (first chart below) that the most recent data for Australia indicate that this Credit Impulse has now peaked and is turning back towards zero.  With a ratio of Private Debt to GDP still in nose-bleed territory (second chart below), deleveraging in the household sector should have a significant impact on real estate prices.

The bulls hang onto the hope that demand for housing in Australia far outstrips supply.  Indeed, even the Demographia study highlighted “smart growth” with restrictions on development on the edge of the urban fringe, as a driver of higher prices in markets like Australia.  Maybe, but the skeptic in us wonders why such a large percentage of mortgages on bank balance sheets are loans to “investors.”  We hope these aren’t the same “investors” that were buying homes in Dublin or in California.  For what it’s worth, a 2005 paper by the OECD on Recent House Price Developments pointed to complex and inefficient local zoning regulations among the reasons for the rigidity of supply in Ireland.  According to this paper, heavy land-use regulations in some US metropolitan areas were also associated with considerably lower levels of new housing construction which restricted housing supply and increased home prices.  We would note that these “supply restrictions” didn’t exactly prevent prices from ultimately returning to earth in California (see chart below).

Perhaps Aussie Pride is enough to keep the bubble inflated and prevent folks from questioning the sustainability of ever-increasing housing prices.  Then again, we’re pretty sure our Irish friends would tell you they are a proud people as well.  The Australian banks tell investors that because their mortgages are non-recourse, they do not have to worry about the same types of risks and losses experienced by lenders in the U.S.  Then again, there’s no such thing as a non-recourse home mortgage in Ireland either, so perhaps the Irish banks are a better proxy for Australian bank investors. We wonder how the currency would react should Aussie officials be forced to recapitalize the banking system, given investors’ current optimism on the AUD.  We believe the Australian Dollar has begun a topping process and investors should position accordingly.  Options on lower Australian interest rates also provide investors with a cheap hedge against a bumpy Chinese landing, should policy makers continue to stomp on the brakes with the same delicate touch as my fiancé’s foot on the pedal.

Disclosure: At the time of publication, the author was short the Australian Dollar, Australian interest rates and various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.