Sausage factories get a bad rap. They’re evoked whenever we’re asked to imagine an unhealthy and disgusting process, because presumably a peek inside one would turn even Ted Nugent vegan.

Yet many of us somehow manage to enjoy our sausage despite that unsavory association.

Substitute MLPs for sausage and you get to the heart of the long-running debate over master limited partnerships.

Critics focus on the industry’s potential and real conflicts, generally revolving around the numerous ways unscrupulous managers can abuse unsophisticated and unsuspecting limited partners.

Defenders use the superb returns MLPs have delivered over the last 15 years to dismiss such nagging as sour grapes.

And yet the future performance of MLPs will depend neither on skullduggery nor on the achievements of the past. It will be shaped by business fundamentals and investor perceptions of a given partnership’s prospects relative to the available alternatives.

At the moment enthusiasm is naturally running high for a market niche that’s delivered superior performance. Valuations are no longer cheap, to the extent that those juicy past returns may not repeat.

But many MLPs are still profiting handsomely from the domestic drilling boom that’s turned the energy sector into the leading US growth industry. It’s not always pretty, but they’re making sausage with real meat, not filler.

Those are just some of the themes I spoke about at the investing conference hosted last weekend by Investing Daily’s Wealth Society. I covered some of the tricks of the trade as well as our investing philosophy and the past year’s strong performance. You can view the full slideshow I used here. I’ll use a few selected slides to summarize the key takeaways below.


So yeah, Barron’s feels bad for all you saps who, long ago, because you didn’t know any better, got suckered into buying sausage with such poor nutritional value. How poor? This poor:

MLPs have produced five times the annualized total return of equities over the last 13 years. Cumulative return charts make a similar point: 


It takes many very good years and very few bad ones to drive this level of outperformance:

And of course it takes a great fundamental story:

And the EIA has been behind the curve on the extent of the domestic energy revival in recent years:

So, let’s review the advantages of MLPs.



The only problem is…

The first three bullet points are related and self-explanatory. But the role of sentiment needs some explaining. In every bull market, the bullish rationale shifts over time from whatever the fundamental catalyst happens to be – shale drilling, railroads, the Internet – to the fact that prices keep going up and in so doing lead market participants to expect that they will keep going up, which becomes a self-fulfilling prophecy and a self-reinforcing dynamic. The longer and stronger the past gains the more buyers will tend to buy out of expectation that the trend will persist, until the trend can no longer be justified by the fundamentals. Are we past that point? I think not. But are we closer to it than we were five years ago? That’s a pretty safe bet.

Recent gains in MLP unit prices have, in fact, begun to outpace the fundamentals, as the valuation chart below shows.

As you can see, MLP valuations are near the upper bound of their four-year range, though still below the peak set in late 2010. That top came as natural gas production soared in the early stages of the fracking boom, but before the resulting glut would slash the price by more than half.

MLPs looks more reasonably valued comparing their yield to that of Treasury bonds:

The chart above shows the current spread slightly above the historic median, suggesting no overvaluation relative to fixed income. But is that really a fair test?

Whether we compare MLPs with equities or bonds what’s indisputable is that they’ve become much more popular over the last four years, as the next three slides demonstrate.

Predictably, supply has increased dramatically alongside demand, with record numbers of MLP investment vehicles and initial public offerings launching last year:

Given the higher cash flow valuations accorded to MLPs, it shouldn’t come as a surprise that…

To better understand why look at the math of Devon Energy’s (NYSE: DVN) merger of its midstream business with that of Crosstex Energy:

Or at the spinoff by Phillips 66 (NYSE: PSX) of its logistics arm into Phillips 66 Partners (NYSE: PSXP) via last year’s hottest IPO:

MLPs offer a significant tax advantage by deferring taxation on the bulk of the income they generate, permanently so for those willing to hold them until death. But at this point it’s fair to wonder whether those tax advantages are fully priced in, especially given the yield advantage of MLPs in the current low-return environment:

High current yields are sometimes used to justify current MLP valuations and to extrapolate continuing gains:

But we know that MLP distributions do not always reflect the underlying health of the business, especially given the wide latitude the partnerships have in calculating their distributable cash flow. Selling debt and equity to invest in future growth is a viable business strategy. But the capital raised can also be paid out as distributions, providing the appearance of success but building no long-term value.

The MLP legal structure is notoriously poor at protecting the interests of limited partners from encroachment by unscrupulous managers. As detailed in a recent article in Pensions & Investments (subscription or incognito browser window required), for example, Delaware law on partnerships allows MLPs to severely limit or even eliminate managers’ fiduciary duties to limited partners in their founding documents, which ordinary investors almost never read.

Incentive Distribution Rights (IDRs) are another scheme general partners use to enrich themselves at the expense of limited partners over the long haul, one reason we’ve leaned whenever possible toward recommending publicly traded general partnerships over the partnerships they manage.

The next four slides detail our approach to such challenges here at MLP Profits as well as our fortunate recent record, followed by a presentation summary. Please note that all of the performance numbers are as of April 25.

‘
I would only like to add how much I enjoyed the opportunity to meet, and learn from, some of our subscribers, and how much I’m already looking forward to next year’s event, tentatively planned for Denver. I hope to see you there.