A Risk-Appetite Renewal

During the energy sector’s crash, investors debated whether the eventual recovery would be “V”-shaped or whether energy prices would remain “lower for longer.”

Among the corporate chieftains who oversee the nation’s energy production and infrastructure, however, I recall a nearly unanimous consensus that energy prices would be lower for longer.

Although my own sympathies were aligned with the lower-for-longer crowd, I couldn’t help wondering if energy markets would somehow upend these expectations, just as they had similarly upended expectations when oil was trading in the triple digits.

That’s because I get uncomfortable when everyone agrees about where a market is headed.

Back in my days at The Hulbert Financial Digest, we used to monitor investment newsletter sentiment toward the stock market.

Typically, we analyzed the readings of our various sentiment indexes from a contrarian standpoint. In other words, any time sentiment reached an overwhelming consensus—either bullish or bearish—the market was generally poised for a reversal.

Of course, commodity markets are rather different than stock markets. After all, they involve finite resources that are absolute necessities for modern civilization.

Sure, there are now all sorts of ways speculators can cause prices to deviate from the underlying supply-demand balance. We saw that happen as oil prices reached dizzying heights during the summer of 2008, then again as crude plumbed an unsustainable low in early 2016.

While the stock market is subject to the laws of supply and demand, commodities are even more closely tied to such economics.

Certainly, no one is more aware of the supply-demand balance than energy sector CEOs, at least when the giddiness of boom times gives way to the reality check of a bust.

And it turns out they were right. Although oil prices have rebounded from their lows, they’re still well below their highs.

The slow recovery along with other more industry-specific concerns led the midstream space to suffer its second retrenchment of the past three years. The exhilarating rally in 2016 gave way to another soul-deadening decline in 2017.

While the overall stock market climbed 19.4% on a price basis last year, the Alerian MLP Index declined nearly 13%. Some MLPs even came within shouting distance of the lows they saw amid the crash.

But a new year brings renewed risk appetites.

MLPs are up 14.1% since their late-November low, with about a third of that gain coming just this week.

The fact that supply and demand is coming back into balance should provide a nice tailwind for MLPs this year.

Further, a number of midstream complexes continued the hard work of simplifying their empires, reducing leverage, and implementing changes with an eye toward greater self-sufficiency.

Though this process has hardly been pleasant, the sector should ultimately be rewarded for its efforts.

Additionally, the tax bill could help attract more investor capital to the space since tax rates were lowered on the portion of returns that are considered ordinary income.

While that may be largely academic for most retail investors, who tend to buy and hold MLPs for the long term and even pass them along to their heirs, it could increase demand from other classes of investors who have different concerns.

Meanwhile, the tax bill could reduce the number of entities that decide to organize as MLPs in the future. That’s because the lower corporate tax rate reduces the appeal of one of the MLP structure’s main incentives.

That may also seem largely academic. But if existing MLPs remain attractive to investors of all stripes, then there will eventually be more money chasing a more limited pool of securities. Here, too, the laws of supply and demand come into play.

Lastly, fresh off a major legislative victory, President Trump is gearing up to push Congress for an infrastructure bill.

Although Congress doesn’t appear to view this as a priority at present, that could change.

Even so, companies have hardly been hurting for capital given the historically low interest rate environment. And while rates are rising, they remain relatively low compared to previous cycles.

And corporate tax reform just freed up more cash for investment.

But since a number of our stocks are essentially infrastructure plays, we’ll take all the help we can get.

To that end, we’re still waiting to see how the tax extenders bill shakes out. This legislation would pick up some of the items that were orphaned by the tax bill.

In particular, it would be good for MLPs to get a carve-out for interest deductibility, rather than be subject to the same limitations as far less capital-intensive industries.

In reviewing a draft of the tax extenders bill filed late last year, most of the energy-oriented initiatives pertained to renewables. But that could change if industry lobbyists have their say.

Portfolio Update

Although Daimler AG (ADR: DMLRY, OTC: DDAIF) sports one of the lower yields in the Income Millionaire Portfolio—recently around 4%—it’s had one of the best performances so far.

Since Daimler was added to the portfolio on July 3, the stock has gained nearly 21% on a price basis.

However, before we get too carried away by this performance, we should note that about a third of the gain is due to appreciation of the euro against the greenback.

But even if we back out the currency-related tailwind, a 13.9% gain in local currency terms is pretty good for just six months.

The one downside of this dividend stock is that its payout only comes once a year, generally in early April. So we’ve yet to even collect our first dividend.

For much of the past two years, the luxury automaker’s stock had been largely spinning its wheels, after dropping nearly 46% from its all-time high.

That left Daimler at a dirt-cheap valuation, though the stock’s rally has brought it back to parity with its U.S. peers from a price-to-earnings (P/E) standpoint.

Still, the highly cyclical auto sector remains quite cheap compared to the broad market.

From a valuation perspective, the auto sector typically lags the broad market. And, of course, it’s hard to shake off memories of what happened to some of the marquee names during the Global Financial Crisis.

But Daimler isn’t as stretched financially as its peers. Indeed, it boasts an “A”-range credit rating from all the major rating agencies.

And its payout ratio is just under 41%, so it still has room to grow its payout, which is expected to rise around 4% annually over the next few years.

However, earnings are forecast to largely tread water during this period.

While sales of its flagship Mercedes-Benz line are performing well (around 56% of revenue), truck sales (21% of revenue) remain off about 7% from their peak in 2015.

The good news is that sales growth in the truck segment has rebounded in recent quarters. And management forecast a “significant increase” in volume for full-year 2017, thanks to recoveries in key markets around the world.

The one potential overhang is that Daimler and its major German competitors, Volkswagen and BMW, could face hefty fines due to charges stemming from allegations of decades-long collusion regarding technical standards.

EU regulators are conducting a probe, but it will take a while and may not result in any evidence of wrong-doing.

Meanwhile, Daimler is also pressing ahead on strategic plans to unlock shareholder value by separating its Mercedes and trucks divisions.

The new structure would transform Daimler into a holding company that treats each of its three main divisions—Mercedes, trucks, and financial services—as independent units.

Industry observers believe these moves could set the stage for a spinoff of its truck operations or similar corporate actions.

But given the interests of entrenched union stakeholders, the resulting negotiations mean this plan will likely take a while to come to fruition. Daimler remains a Buy.

In housekeeping news, Cone Midstream Partners LP has changed its name and ticker to CNX Midstream Partners LP (NYSE: CNXM), effective Jan. 4. This change followed the closing of Noble Energy’s sale of its general partner interest to joint-venture partner CNX Resources Corp.

This transaction was part of the series of transactions Noble undertook as it sold its various stakes in the midstream venture. CNXM remain a Buy.

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