You know what causes a 100% loss for investors of publicly held corporations? When the Board of Directors holds a vote to dissolve the corporation, gives advance notice to all creditors, files the dissolution paperwork with the Secretary of State, it then takes the residual assets and returns them proportionally to the shareholders. You know what doesn’t signal the death of a corporation? A dividend cut.
I nodded to Polonius there because there are people who respond to dividend cuts as if it were the end of a corporation’s existence when in fact the shareholders own something quite precious–a proportional claim on all future earnings and dividends that each share represents. Especially in the field of commodities, automatically selling in response to dividend cuts is one of the worst strategies you could ever employ because you will be selling low and then have to watch the stock price climb and dividend payouts quickly recover when the cycle returns.
That’s just life. Some people pretend that indexing is the answer to avoiding volatility, but that is just cosmetic ignorance. If you had put all of your money into an S&P 500 Index Fund in June 2014, you still were investing 3.3% of your cumulative wealth into the common stock of ExxonMobil. It is the exact replica of having a portfolio with 33 individual stocks and allocating one of the positions to ExxonMobil at the same time. You still participated in the share price decline from around $105 to $74. It’s just in the case of the index fund, you don’t see it directly as the investment is shrouded amongst a conglomeration of 504 other stocks in the S&P 500 while the portfolio of individual stocks permit you to fully see which company is appreciating or depreciating your net worth in real time.
And you need to calibrate your instincts correctly to recognize the margin of safety that is often attached to an energy company following a dividend cut. One of the first master limited partnerships I ever covered was Boardwalk Pipelines. It was an MLP that cut its distribution in February 2014, and I wrote an article about it on February 13, 2014. I called it a steal at $13 per share.
If the commodities markets performed well, Boardwalk unitholders would double or triple their money quickly. If they performed poorly, the depressed price of the dividend cut offered protection that would limit further capital losses. Little did I know, the commodity prices would do allright between February and the summer of 2014, and then begin a deep cyclical downtrend that would harm the midstream energy produces that employ a lot of leverage and experience wild fluctuations in profits.
But the point stood: Even if the low end of estimates panned out, Boardwalk still offered better protection than the alternatives because of the unusually cheap price that corresponded with the dividend cut. Since I wrote that article? Boardwalk is down 25% counting distributions, turning a $10,000 investment into $7,500. If you instead put your money into The Barclays Midstream MLP Index, which is the index fund for firms that share the same operating characteristics as Boardwalk Pipelines, you would have lost 47% of your initial investment and turned $10,000 into $5,300. The difference between seeing an account balance of $5,300 and $7,500 can be attributed to the margin of safety that was inherent in the price of Boardwalk stock after the dividend cut. When the price of oil rises, Boardwalk will rise more than the index as a whole. The margin of safety principle is both a sword and a shield–it limits losses on the way down, and provides additional capital appreciation on the way up.
Kinder Morgan has great pipelines and terminals. Everything about the business touting its greatness is still true–it is profitable even in this current oil environment. The big demerit against the company is that it took on gobs and gobs of debt to repurpose itself as a fully owned pipeline corporation after buying out the general partnership interests that were structured as MLPs across three companies. It has $44 billion in debt on the balance sheet as a result of this.
Much of that debt is deferred beyond five years. In the next five years, Kinder Morgan only needs to come up with $11.7 billion in payments. The actual structure of the payment is as low as $1.7 billion in some years and as high as $2.4 billion. Even right now, Kinder Morgan still generates a little over $4 billion in annual cash flow. Even if the status quo remains, the most vulnerable point is a year in which Kinder Morgan must devote 60% of cash flow to paying off creditors.
There will come a time when the price appreciation and dividends from this low $13 price point will be enormous. The sequence of events for Kinder Morgan–taking out lots of debt, seeing cash flows suffer–has been unfortunate. It has caused real harm for shareholders that relied on the dividend payment. But unfortunate circumstances is not a license to act irrationally. In fact, the opposite is required. The more flustering the circumstances, the more necessary a sober mind becomes. If oil revisits 2013 pricing, Kinder Morgan will easily be generating over $6 billion in annual cash flows. These circumstances can, and do, snap in a hurry. And even if the status quo remains, Kinder Morgan will survive as a profitable corporation, even if the style of survival doesn’t conform to a conservative investor’s idea of best practices.
Originally posted 2016-01-22 01:31:33.