A Different Way To Look at MLPs and Energy Infrastructure

April 2013

Jim Murchie of Energy Income Partners shares his views on where to find the most attractive opportunities
The search for yield and the headlines about energy independence have turned investors attention to master limited partnerships (MLPs). But Jim Murchie, a principal at Energy Income Partners (EIP) in Westport, Conn., says that investing in utility-type businesses like regulated pipelines and power transmissionvia companies with high dividendpayout ratiosshould always be part of an appropriate investors overall portfolio. But while the MLP structure is attractivewith no corporate taxation, a high payout ratio and tax deferral on the dividendonly about 25% of MLPs operate non-cyclical utility-type businesses, Murchie notes. The rest, he explains, are generally cyclical businesses and are less well-suited to the structure. Whats more, he says, some attractive companies not formed as MLPs potentially offer higher dividend-payout ratios and are backstopped by non-cyclical businesses. Murchies firm manages about $3.5 billion in assets and runs four exchange-traded vehicles that specialize in energyinfrastructure companies with high dividend payouts. He shared his thoughts about MLPs and energy-infrastructure investments in a recent conversation with Morgan Stanley Wealth Management. The following is an edited version of the discussion. Question: How sensitive are MLPs to movements in interest rates? Jim Murchie: The quarter-to-quarter correlation with yields on the 10-year U.S. Treasury is zero. But that is not to say interest rates dont matter over the long term, because they do. And their impact is related to the duration of the security. The inherent duration of MLPs is higher than [that of] the 30-year bond, but its lower than [that of] equities, because more of the total return of an MLP comes from the quarterly payout than from growth. Its funny to think back on the conversations we have had with investors. When we first started in 2003, it was, Im not going to invest in a yield play in a low-interest-rate environment. Well, okay, As Dr. Phil says, How has that worked out for you? Since October of 2003, when EIP began its first fund, MLPsas measured by the Alerian MLP Indexhave posted average annualized returns of 14.7% (as of Dec. 31, 2012). That total return is made up of an initial yield of 7.1%, average annual growth in dividends of 6.8% and a slight improvement in valuation of 0.8% per year (as measured by the price/dividend ratio). The impact of interest-rate movements is on the change-in-valuation component and should be combined with the contribution of yield and growth to assess total return. Go through your portfolios and for each component equities, munis, fixed income, real estate investment trusts, MLPs, etc.assess prospects for total return by assessing these three components. Look at the yield. Estimate what you think the growth in those dividends might bewhich is always zero for bondsand take a stab at what changes you might get in valuation. Then multiply it through and see what are the weighted average yield, weighted average growth and weighted average expected change in valuation for the portfolio as a whole. Its a sobering exercise. If you think rates are going to go up and its going to hurt valuations, then work it through the rest of that spreadsheet. What do you think its going to do to your equities? What do

you think its going to do to your bonds? It shouldnt be, Im not going to own these because I think interest rates are going up. If you are going to assess what one investment will do under different circumstances, [you should] assess all your other investments [using] the same criteria, all the while recognizing that predicting the future is impossible for most people. When we first started in 2003, questions about interest rates and K-1 partnership tax forms were 90% of the conversation. But its dropped to 30%. In other words, people are more informed about MLPs. Its a more educated conversation. Those two factors still matter, but [suitable investors] now see the other elements they ought to be asking about: the business the MLPs are involved in, the impact of the oil-and-gas shale plays, the tax policy coming out of Washington, etc. Question: As MLPs have gotten more popular, what are the new challenges of your job? Murchie: Ive gone from explaining to people 10 years ago what MLP is an abbreviation for to correcting the misinformation thats out there about MLPs. And we have to remind people not to think of us as an MLP manager. Think of us as investors in monopoly utility types of assets inside companies that pay out a high portion of their earnings in dividends, are well managed and dont have over-levered balanced sheets. And by high payout ratio we mean above 50% and below 100%. In other words, the company has to earn its dividend. Question: Does a more crowded trade make it harder to find opportunities? Murchie: Not really. Crowds cause things to get overpriced and also underpriced. It used to be that most of the MLPs we owned traded within a 200-basis-point yield spread, which meant that they were being priced primarily on yield and not on growth expectationswhich ranged from 4% to 12% per year for the companies we owned. Now you have a situation where the market is pricing in growth expectations, and [these expectations] seem to have an even wider [spread] range than we think is likely over a longer, three-to-fouryear, time horizon. Within the pipeline space, you have some [MLPs] trading at 8% or 9% yields and others trading at 3.5% or 4% yields. Its the first time in MLP history that this has happened within the pipeline space. MLPs with 3% to 4% yields are anticipating above-average growth, usually because recent

growth has been way above averagesay, in the low-tomid teens. But as time goes on, [I think] such growth rates are not sustainable and will revert back to the average. If growth is average, valuation is likely to be average, which for an MLP means about a 6% yield. And going from a 4% yield to a 6% yield is a 33% drop in valuation, which means you need 33 percentage points of growth above the rest of the portfolio just to break even on total return. Likewise, MLPs with much higher yields are associated with companies that have had weak growth recently. If the growth starts up again, the valuation [should] improve and the internal rate of return may very well be higher. Question: So there are more mispricings? Murchie: Yes. While the vast majority of our total return has come from yield and growth and only a small portion from changes in valuation, its still an important component. Question: Do you think MLPs should be part of an overall balanced portfolio? Murchie: What I find people doing is segmenting their portfolios into yield, growth and value components. And in each categorysay, the yield or income categorythey focus on that characteristic and less on the other two. Value managers become enamored of how cheap their stocks are. Income managers focus on the yield and growth managers on growth. But since the total return of any investment is a function of the yield, growth and change in valuation, I think all three components need to be assessed, regardless of which box the strategy is part of. Maybe youve found a really good value manager whose return all comes from change in valuation. Thats fine; just understand thats where your return is coming from. For us, most of the return [potential] over time will come from yield and growth, which means the return is coming primarily from the underlying businessnot portfolio turnover from one stock to the next. So, yield investors: Beware of negative growth rates. We have had 19 dividend cuts in the MLP space in the last four years, all from MLPs involved in cyclical businesses. Question: The MLP space has grown a lot, and there has been a lot of share issuance and new MLP funds created. Is this something investors should worry about? Murchie: MLPs have a lot of investment opportunities today to build new infrastructure. Since an MLP pays out all its cash every quarter, new projects or acquisitions need to
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be financed with new issuance of equity and debt. The MLP space has grown by about $200 billion over the last six years; $100 billion of that is financed with equity, and only $25 billion of the $100 billion was bought by MLP funds. So demand hasnt grown with supply. The capital-markets guys would tell you thats why MLPs are trading at the same yield today as five years ago vs. REITS and bonds, which are 200 to 300 basis points lower. Nearly the entire return on MLPs has come from yield and growth, with little change in valuation. Question: What are some of the other concerns you have been hearing from investors? Murchie: MLPs sold off right after the election. People wonder whether MLPs are going to lose their tax-favored statuseither as the result of comprehensive tax reform or because Obama just doesnt like the oil industry. But MLPs cost the government less than $2 billion per year, and they spend $20 billion to $30 billion a year building new pipelines. That has helped to cut the natural-gas price by more than half and dramatically reduce oil imports. Another thing for investors (like us) in pipeline MLPs is that pipelines now qualify for REIT tax treatment because of a private-letter ruling from the IRS about five years ago. In fact, there is now a publicly traded energy REIT. Question: Can you go over the tax treatment of portfolios that have a mix of MLPs and other assets? Murchie:. Mutual funds have many rules and ratios they have to adhere to or they lose their tax-free M-corporation status. One of those rules is keeping partnerships below 25% of the portfolio. The MLP funds out there with the worst performance are the open-end MLP fundsbecause they incur an extra layer of tax at the fund level. What that means is that for every 10% the portfolio [potentially] appreciates the net asset value only appreciates [by about] 6.5%. We offer a managed ETF that keeps partnerships to just under 25% and invests the balance in other non-cyclical energy infrastructure companies, many of which are affiliates or parents of MLPs. Our [specialty] spans the energy markets and is not limited to MLPs. This allows us to offer products that are far more diversified and tax-efficient yet still offer the characteristics investors are seeking.

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