The Beauty of A Flexible Income Investing Strategy

Pipelines have been a glorious way to build long-term wealth, particularly if you are willing to accept hiccups in income and think broadly about total income generated over the course of a full business cycle. Because natural gas storage is at a low point in its own business cycle, Boardwalk investors have had a rough year, suffering a distribution cut of 81%. Truly patient investors, though, should have a promising decade ahead from this price point.

Pipelines have been a glorious way to build long-term wealth, particularly if you are willing to accept hiccups in income and think broadly about total income generated over the course of a full business cycle. 

In February, I wrote an article titled “Why Boardwalk Pipelines Is An Absolute Steal At $13.” That article was uncharacteristic compared to the high-quality dividend stocks I usually discuss because it involved a highly unique set of circumstances coming together. To summarize the obvious: you had a pipeline that had never lowered its distribution since becoming publicly traded in 2005 suddenly slash its distribution by 81%, from $0.535 to $0.10 quarterly. Because most energy MLPs are held for their ability to return large amounts of cash to unitholders, most long-term investors in this MLP had a “WTF Am I Doing With This Albatross In My Portfolio?” moment, cutting the price of the partnership in half within a single day of trading.

At the time I wrote that article, the thesis was more of an approximation than a precision. I couldn’t, and still can’t, articulate a moment in which I could promise that the distribution would begin rising again. This wasn’t a situation like buying Procter & Gamble stock where you can say, “Okay, the distribution is going to increase by 7-10% each year.” No, it was nothing like that. Instead, the thesis was more along the lines of this: the value of the MLP is substantially greater than the 50% hit it just took, and at some point, it will be able to generate significant income in relation to the $13 per share purchase price. The comeback could start next year, it could start in four years, and it could take ten to fifteen years to materialize, and the ride might even be super bumpy, but for the truly long-term capital, there is a very interesting opportunity here.

What caught my attention was that, despite the trouble in the storage and distribution of natural gas space, the MLP was still making $240 million in profit per year—even counting the headwinds. It’s going to continue for the next couple of years—when you have an oversupply of natural gas like we do in the United States right now, there is less incentive to store and transport the stuff because, well, it’s everywhere. Usually, these storage contracts are over rolling bases of a few years, so each contract renewal is coming in at a lower price. That’s why the distribution got cut—2015 could be a tread-water year at best, a slightly worse year than 2014 if you’re being realistic. With distribution cuts and a guaranteed waiting period for profits to rise, you can see why investors would say, “Life’s too short, I can find easier ways to make money.”

But going back to Graham’s margin of safety principle, the problem with Boardwalk was that the dividend (err, distribution) payout had gotten so high that the firm could not withstand an extended period of bad years, and really, that’s something that typically occurs in any commodities business. But now, you have a situation where only $97 million in distributions is getting paid out while the firm generates $240 million in profit. At $13 per share, that source of value became substantial for people looking out 10+ years.

That’s why, ultimately, it is more important to think than develop bright-line rules or rigid structures for investments. One of the advantages of having a portfolio stuffed with high-quality securities is that you can take a chance here and there on a lower quality offering that offers more promise. So far, the results from Boardwalk have looked good. Since my February article about the MLP at $13, the price has increased in the past four months to $17.39 for a gain of 33% over the period.

That’s the beauty of it all—if you get too rigid or absolute with your criteria, you’d never find yourself owning something like Boardwalk, which is probably going to deliver substantial income and capital gains over the coming decade from that $13 price point. The usefulness of having a portfolio stocked with Coca-Colas, Johnson & Johnsons, Colgate-Palmolives, Nestles, PepsiCos, and ExxonMobils is that you can go after a low-quality holding that has been beaten down too much when the opportunity presents itself. If you’re wrong, the dividend growth rate from your other holdings will pick up the slack, so that a year or two of dividend growth from your other investments could advance you forward even if the low-quality holding goes bankrupt. And, if you’re right that the investment turns out lucrative, then you get to where you needed to be all that much faster.

That’s where the prospectuses for mutual funds of even the most disciplined fund managers still say something like, “We reserve the right to invest 10-20% of the fund in ways the manager may see fit, even if it seems to go against all the objectives of this fund.” It satisfies your intellectual curiosity* by letting you see whether you can apply these abstract investing principles in a very real way when the decision you are making is currently unfashionable, and it’s a reminder of why Benjamin Graham built his legacy on the backbone of cheap stocks. You probably wouldn’t want even 20% of your portfolio filled with the Boardwalks of the world, but 5-10% makes for an intellectually rewarding investing life that can get you richer, faster if done right, but can be easily mitigated if you are disastrously wrong.

*= Interestingly, the T Rowe Price Fund Family permits its managers to stray beyond fund objectives for reasons that have nothing to do with satisfying the intellectual curiosity of their fund managers. In their case, a bunch of managers of small-cap and mid-cap T Rowe Price funds had held Wal-Mart through the 1980s and early 1990s. When the stock became a large-cap, though, the charter for the fund wouldn’t permit them to hold it, forcing them to sell not only a stock that they thought still had great potential, but the fundholders had to pay a substantial capital gains tax on the appreciation as well. That fiasco caused T Rowe Price to change the rules so that managers wouldn’t be forced to sell when some of their holdings experience style drift. 

Originally posted 2014-06-05 22:57:11.

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