Few people complain when unit prices rise but when a pullback occurs it often feels as though you own too much. The MLP group has enjoyed another solid year (so far) of unit price gains coupled with distribution growth, but a recent pullback of approximately 7% has caused some stomachs to churn. My contrarian nature tells me that when everyone is bullish, I should be cautious and when everyone is scared, I should be emboldened. Equity market corrections can be a healthy part of an overall bull market run and the key is to understand the difference between a correction/pullback and something more insidious.
It’s important to separate fundamentals from emotion in any asset class correction. The trends in underlying business fundamentals allow you to focus your analysis on reality and not the churning feeling going on in your gut. Every experienced MLP investor understands that the group has enjoyed a very strong rally from the lows of 2009 driven by strong/growing demand for critical energy infrastructure, an improving (lowered) cost of capital and solid project level execution. The energy renaissance we often hear about in the United States is providing an unprecedented opportunity for many of the best-positioned midstream energy infrastructure companies to succeed. The ability to deploy capital with returns well in excess of the cost of capital is providing the fuel for the strong (and visible) cash distribution growth investors find to be so enticing. This combination of yield plus growth (in a low to no yield environment) has attracted more capital to the group, which has helped to push valuations higher.
I have been telling anyone willing to listen that the MLP group was likely to see a pause in its rapid climb during the second half of 2014. While the business outlook remains robust, the group needed a chance to grow into its recently elevated valuations. Valuation does matter and when you begin to hear that it “doesn’t matter anymore” that is the time to get worried. While MLP valuations have moved to the high-end or beyond historic valuation ranges, my team and I have felt that the energy midstream super-cycle would support current price levels. This doesn’t mean the group will be immune to bouts of profit taking possibly instigated by renewed fears of rising interest rates. I will leave interest rate forecasts to others—the purpose of this post is to emphasize that corrections or pullbacks should not be feared. Instead, they should be expected and utilized to enter the group at better levels.
Any correction will usually test the nerves of investors. If you do your homework and know what you own and why you own it then if a sale occurs you should be happy to take advantage of it. If you love an article of clothing at a store and come back a week later to find it 10% cheaper then you should like it that much more (assuming the quality of the garment is the same). This thought process works for companies as well. Certainly, some of the higher-flying, high growth MLPs moved to value levels (yields below 2%) that raised a few eyebrows. Those names tend to correct more on a percentage basis when the entire group pulls back. However, the fundamentals that drove those companies to the higher valuations have not changed. Therefore, if you believe in the outlook then they have become more attractive. Rising interest rates are assumed to be a negative for the MLP group, but the historic data is not as clear and the group has shown positive performance in 5 of the last 6 rate rising periods (dating back to the 1990s). Higher distribution growth should act as a good defense against inflation and rising interest rates.
I continue to believe that the long-term outlook for midstream MLPs is upbeat – driven by strong demand for their core assets, which lead to visible and predictable cash flow growth. Material corrections/pullbacks should be used as an opportunity to initiate or add to positions in best of class names. It’s hard to know how deep a correction will go and when it will end, but if you have studied the fundamentals of what you own then you should remain confident in the overall outlook.
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.