During 2009, the Alerian MLP Index (NYSE: AMZ) delivered a 76% total return.
However, it is important to remember that the AMZ fell 37% in 2008. Because compounding off a lower base makes a significant difference in returns, the index needed to recover 59% in 2009 just to break even. Many actively managed MLP funds fell more than 60% in 2008, and so they would have had to return 150% in 2009 just to break even.
Given the confluence of events in 2008 – the collapse of two large MLP-focused hedge funds (GPS and Lehman Brothers), the exit of many banks from the MLP swaps business, and forced deleveraging by funds during the credit squeeze – MLP performance was artificially depressed.
As a result, although 2009 returns appear extraordinary at face value, in the context of a two-year period, the AMZ rose a tempered 11%. Although this significantly outpaced broader equities as the S&P 500 fell 20%, MLPs still present a strong buying opportunity at current levels. Instead of focusing on 2009 headline performance, investors should consider the fundamentals and valuation.
Toll-Road Model Proves Stable
Many MLPs have toll-road business models. They (1) receive a specified tariff for hauling a product over a certain distance; (2) do not take title to the commodities they transport; (3) are agnostic to the absolute level of commodity prices because these prices do not enter the revenue equation; and (4) do not have significant credit risk as commodity prices rise or fall.
As a result, these toll-road business models produced consistent margins and performance over the tumultuous economic period of the last two years. The margins earned by pipeline and storage assets in particular were largely unaffected by the commodity collapse of 2008 and the subsequent rebound of 2009.
Valuation Today
We prefer to value MLPs by discounting cash flows at conservative, asset-specific required rates of return. Our analysis indicates that the group, on average, is close to being fairly valued. But that does not mean that investors should not add to positions. Current net asset values discount low-teens equity returns for the sector, which we believe is highly attractive in this or any market, especially on a risk-adjusted basis.
Drilling down further, some large-cap MLPs have catapulted ahead of themselves, which is normal for an economic recovery and the resulting flight to quality. But we continue to see strong value, particularly in the mid-cap space, and solid opportunities to put money into undervalued businesses with upside potential due to asset positioning, management acumen, or both. Generally speaking, we see the greatest number of opportunities in the refined products pipeline and storage group.
As compared to other asset classes, MLPs also remain attractive on a yield basis. Further, our expectation for 4% average distribution growth in 2010 compares favorably to that of other yield-oriented investments.