Week 39: So What’s An MLP, Anyway?

If you can’t explain it to a six year old you don’t understand it yourself
— Einstein

Please refer to Important Disclosure Information at the end of this research note.

The Markets

The S&P 500 (i.e., the “market”) is now down a little more than 5% this year, excluding dividends.  The market was actually up for the week - in your face, Volatility! 

If you’re an income investor owning Master Limited Partnerships (MLPs) you probably had more excitement this week than you cared for (more on this below). 

With the benchmark 10-year Treasury note still yielding 2%, we remain comfortable with a principal-protected 5%+ dividend yield income portfolio.

Are We In a Bear Market?

In our last weekly report, we asked and Forbes answered, running an article, titled “Are Stocks Headed for a Bear Market?”

Seven investment strategists (including us) shared their views.  Our views are essentially that we’ve reached a fork in the road.  Monetary policy (i.e., QE) has run its limits and now we need something else, possibly fiscal policy, to drive corporate earnings.  If we get it, then the markets will grow into its current valuation. If not, we may be looking at a very expensive market. 

With the "wisdom of crowds," the market is good at assimilating all publicly available information, but it cannot cope with high uncertainty.

Understanding the U.S. Unemployment Rate

There are few metrics that are as polarizing as the U.S. unemployment rate.

The optimists point to the low 5.1% unemployment rate as a sign that the economy is improving.  The pessimists claim that the unemployment rate is not a good economic barometer. 

To understand who’s right, let’s see how the rate is calculated.

According to the BLS’s household survey, the civilian labor force was 156.715 million, down 350,000 from the prior month.  The civilian labor force comprised 148.800 million employed and 7.915 million unemployed.

Those not in the labor force was 94.610 million, up 579,000 from the previous month.

The unemployment rate is calculated as follows:  7.915 / (148.800+7.915) equals 5.1%.

It’s worth noting that both the employed and the unemployed decreased in September but those that left the labor force (perhaps because they couldn’t find a job) increased in September.   

So the unemployment rate benefited from a lower number of unemployed (positive) and a higher number of civilians who left the labor force (negative).

So who’s right, the optimists or the pessimists?

Master Limited Partnerships (MLPs)

The Alerian MLP index is down 23% for the year, and even the 8.8% dividend yield doesn’t cover the loss of principal.  Barron’s stirred up a hornet’s nest last week with a series on MLPs which can be found here, here, and here.

If you own MLPs, I highly recommend reading them.  If you don’t own MLPs they're still worth reading because they raise important questions about how market participants process the same data.

While MLPs at today’s prices may represent attractive value, we don’t own any in our Income Portfolio because frankly we don’t understand them and we can't explain them to a six year old.

If you do own MLPs or are planning to own some, it may be worth asking these questions:

  • Is the dividend safe?  Is it covered by both current and future distributable cash flows? What is the average contract duration?  If its 10 years on “average” does it mean there are some contracts that are much shorter leading to an unexpected drop in cash flows and potentially stressing the dividend?
  • Is your principal safe? If the yield increased to 15% from 10% due to a fall in share price what does it mean for your investment? Your principal is now down 33% and you may need 3.3 years of dividend payments just to recoup the loss of principal. 
  • What is the counterparty risk?  Even if the MLP does not take commodity price risk (such as oil price risk), its customers may.  Will their customers be able to honor the contracts? Could the customers force a contract renegotiation cutting payments and impacting the dividend?

 

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