What I Wish I Had Known Before Investing In MLPs

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Includes: AMID, AMLP, BPL, IYR, MLPA, VNQ
by: Jussi Askola
Summary

Every investor makes mistakes. The most important is to learn from them.

Today, I allow you to learn from all the costly mistakes that I made in my early MLP investing career.

Some discussion on MLP investing strategies and how to maximize performance.

The best way to learn how to invest money is to make mistakes and then to learn from them. The problem with investments is that even small mistakes can be very costly!

I was lucky to have gotten started on this journey at a very young age when my capital was limited to savings from summer jobs and other side hustles. I made many mistakes, lost money along the way, learnt from my past missteps, and became the (hopefully better) investor that you are today reading on Seeking Alpha.

In an effort to pass along some of my costly lessons as a MLP investor, I describe a few points that "I wish I knew" before I started investing my hard-earned capital. This is especially relevant today as many investors are considering getting back into MLPs while yields remain at historically high levels:

Source

Confusing Categories of MLPs

The MLP market is very vast with over 100 names - representing billions and billions worth of infrastructure in the US alone. This can get overwhelming at first. What makes it even more difficult is that each MLP is very unique in its structure, investment strategy, targeted investments, management quality, and balance sheet safety.

First off, it is important to distinguish between the three main categories of MLPs: Upstream, Midstream, and Downstream.

  • Upstream MLPs are involved in the exploration and production of crude oil, natural gas and natural gas liquids.
  • Midstream MLPs are involved in the gathering, storage and transportation of oil and gases. Midstream MLPs are often referred to as "Pipeline MLPs".
  • Downstream MLPs are involved in the distribution of the oil and gases to the end customers.

Then after this first categorization comes all the different MLP subsectors including:

  • Oil and natural gas
  • Oilfield services
  • Propane
  • Marine transportation
  • Coal
  • Other natural resources

Each sector has its unique risk and return characteristics, and picking the right sector at the right time demands specialist skills that I was lacking back then. I went ahead and invested in MLPs without paying attention to these differences - setting the wrong expectations on day 1.

Lesson: There are important differences between different sectors that you need to understand before investing in MLPs. As an example, midstream MLPs may enjoy very consistent cash flow while upstream MLPs experience a roller-coaster ride. Knowing where the differences are can literally "make or break" your MLPs investments.

Management Alignment is More Important Than Anything Else

In my initial years as an MLP investor, I put considerably more weight on the quality of the assets and balance sheet than the management. My rational back then was that anyone with a good background would do (almost) equally as well. After all, this is not rocket-science, right?

Well, turns out that this may have been the costliest assumption of my early MLP investing career. The quality of MLP management teams can be very volatile with large discrepancies in skills, motivation and interest alignment.

It is not uncommon for parent companies/general partners to take advantage of their MLP entities by charging excessive fees while also issuing significant amounts of equity and debt in order to grow as much and as quickly as possible to line their own pocket books through fees. Meanwhile, unitholders in the MLPs would suffer significant dilution as well as overleveraging that contributed to the massive sell-offs in unit prices and distribution cuts that rocked the sector and scared many investors away for good.

Example - To put theory into practice, consider the case of American Midstream Partners (AMID), which cut its distribution last summer, sparking a massive sell-off in the shares. A prudent investor would have seen numerous red flags signaling the impending cut as it suffered from dilutive equity issuances, poor management execution, and mistreatment from its general partner (ArcLight Capital, whose energy division has unsurprisingly recently taken AMID private at a very cheap valuation). We managed to avoid the pain by sticking to well-managed MLPs that have their interests closely aligned with the investors.

Lesson: Long term-oriented investors should put a greater focus on management quality than anything else. Over the long run, as the superior management keeps on making the right decisions, the value keeps compounding at a faster rate.

Never Lose Sight of "Value"

MLP investors tend to be very impatient and will trade in and out of their positions based on the next quarter's outlook - causing massive disparities in performance. To maximize your chances of being on the right side of the trade, it pays to keep a close eye on the valuation metrics.

Price is what you pay; value is what you get. In this sense, a great company won't make a great investment unless the price is right. Many blue-chip MLPs are overpriced relative to some of their lesser-known smaller peers today.

Sometimes an MLP may also get stigmatized due to past issues that are mostly resolved and continue to trade at a massive discount to peers. This has allowed us to profit from the latest buyout in Buckeye Partners (BPL). The company had some clear issues, but the market had so heavily discounted its unit price that we saw an opportunity to invest in a hated company with a large margin of safety. Soon after, the company got bought out and turned a major profit to investors.

Lesson: It is easy to get sold on the quality of operations and to forget to ask what price you are paying for it. The price is just as important as the underlying fundamentals. They go hand in hand and should never be considered in isolation.

Leverage Does Not Automatically Equate to Higher Risk

Most investors appear to ignore that certain MLPs can bear more debt than others. As an example, a midstream MLP with investment-grade contracts and stable cash flow is likely to enjoy more consistent cash flow throughout the entire market cycle. Therefore, it is much more reasonable for them to leverage up the balance sheet than an upstream MLP which may be more cyclical. In many cases, even with greater leverage, the midstream MLP may turn out to be less risky.

Therefore, it is not enough to screen MLPs based on generic metrics of a screening tool. Rather, investors should look at the real underlying cash flow, its resilience, and compare the debt level to the peers of its sub-sector.

Lesson: The balance sheet needs to be considered in association with the portfolio and cash flow resilience. Some MLPs can take much more leverage than others and still remain less risky. Generalizations based on generic metrics lead to mistakes.

Passive vs. Active Portfolio Strategy

After close to a decade of MLP investing, I have seen and experienced it all: growth strategies, momentum strategies, value investing, high-yield strategies, special situation, indexing…

There are a lot of different strategies to choose from, but perhaps the easiest option for MLP investing is to simply invest in the broader MLP market, utilizing an index fund such as the ALPS Alerian MLP ETF (AMLP). However, this means buying every MLP in the index regardless of its current price, quality, prospects, or management. While "know-nothing investors" (to borrow a term from Charlie Munger) may find this broad diversification useful, we believe (as does Charlie Munger) that using an intelligent analysis of the qualitative and quantitative aspects of each MLP in order to pick and choose the most opportunistic investments will provide the best total returns over the long term.

That said, analyzing MLPs and designing a portfolio yourself is no walk in the park either. It requires specialist skills that are not widely available, and there is a strong need for professional research to sort out the worthwhile from the wobbly.

In my early investing career, I made the common mistake of being overconfident. I thought that I knew it all and beating indexes would be easy-peasy. I was overly concentrated in a few risky bets and a single mistake end up costing me a lot in performance.

Lesson: The lesson here is to keep a realistic view of your limitations as an investor. When I started out, I had minimal real-life experience and very limited resources (expertise, capital, time). In this situation, passive indexes would have been better adapted for me.

Closing Notes: Are MLPs the Biggest Opportunity of 2019?

Priced at a huge discount to other asset classes, there's no doubt that there exist some lucrative opportunities in the MLP space today:

  • MLP (MLPA) average dividend yield: 8.4%
  • REIT (VNQ; IYR) average dividend yield: 4%
  • S&P 500 (SPY) average dividend yield: 1.9%

Moreover, counting out the latest bear market, MLPs have been massive outperformers in the long run:

Source

Now with the valuations at historically low levels, and growth coming back, we believe that the sector is poised for strong future outperformance. We expect significant upside from many of our MLP investments and earn a +10% yield while we wait.

HOWEVER... While it all sounds very appealing, you must exercise very prudent attention to your selection of individual investments as return disparities can be massive. As an example, for every investment that we make, we reject about 10 other alternatives:

High Yield Landlord selection

If you decide to invest in individual MLPs, be very picky and do your homework. Otherwise, it is probably better to accept average results and stick with passive indexes.

Disclosure: I am/we are long SEVERAL MLPS NOT MENTIONED IN THIS ARTICLE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.