Tom's Life Bits

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Suggestions for a newbie's portfolio - 2010 edition
On 11-27-08 I posted "Suggestions for a newbie's portfolio" - http://www.investorvillage.com/smbd.asp?mb=5028&mn=4268&pt=msg&mid=6192270  I thought that thread was due for an update - and before I took some time off from posting on this board [too much frustration from the lack of participation in the credit metric and DCF/unit solicitation project] - I wanted to leave giving the board the correct impression that I was thankful for most of my experiences here.

My thanks to passandshoot, fyrisle, Fugitive Pauper, chamois16, mplaut, sophistabubba, stockmasterflash, vireya and BeholdNebuchadnezzar - all of whom have sent in comments and suggestions to earlier drafts of this message, which were posted in PMs to those in the UBTI project group.

Suggestions for a newbie's portfolio

This 50-something investor in early retirement chooses his investments for both yield and growth. This investor wants an age appropriate allocation to bonds coupled with high distribution/dividend growth from his equities - because it is hard to get growth from bonds. This investor, who wants to have a high bond component, thus demands more growth from his equity income and thus accepts a greater risk in some of his equity choices because of this 'pairing' of investment choices. This investor is somewhat non-risk sensitive. I can deal with turbulence in the pricing of my equity portfolio - but I can not deal with dividend or distribution cuts.

These psychological attributes, these portfolio goals, and these financial needs color my advice. And it is colored by my varying familiarity with investments alternatives. It is colored by the stats that I collect, and the history that is painted by those stats - which may or may not be reflected in forward performance. My stats guided me sell REIT holdings early [due to valuations and having them going over a targeted allocation percentage]. My stats helped me stay light on regional banks and BDCs [the speed of the change in NPAs correctly scared me], bulk up on MLPs [there is less elasticity of demand for energy - so most distributions would be safe], and hold during the turbulence of 2008 and early 2009.

I am reluctant to offer advice to someone who has not expressed their needs or their psychological attributes. Advice is best when served one on one, so it fits the individual. But for a moment, to heck with my reluctance - and here are 10 MLPs / LLCs / GPs that would fit the needs of an investor like me and for which I would suggest a 1% portfolio weighting in each suggestion.

The suggestions below are based on current pricing, current yields, current debt metrics and current CAGR and DCF/unit projections. Those will change over time. So if you are buying into the sector slowly, one needs to be aware of changes in those metrics since the posting of these suggestions. At the end of this message I will post spreadsheets on historical distribution growth, my 5 year CAGR projections, and current price/DCF spreadsheets in the PMed version of this message that will go to those who are contributing UBTIs in that effort - and to a few extra that are helping with metric solicitation. This is the data that I use to justify the selections. But for the benefit of a wider audience, some metric justification is included in this text.

In this environment, I want safety first for most of any suggested portfolio for MLP newbies. I want fee intensive MLPs. I want big caps with the best credit ratings - and I want the credit metrics that would justify those ratings - instead of just trusting Moody's, Fitch and S&P will be on the ball. I want great histories. I want strong distribution/DCF ratios. I will not avoid commodity sensitivity in an MLP as long as I am well paid for the added risk - and as long as that added risk comes with a logical projection of distribution growth. I want to be low on the G&Ps and E&Ps, but I do not want to avoid them.

Buy Three GPs

In a world where distribution gains approach zero, the yields of the GPs will fall to that of the MLP. The GP only has an advantage in a world where there is distribution growth. The pricing of the GPs of the big capped MLPs with long and good histories and strong balance sheets, have always sold with their growth component at a discount. [Companies with twice the dividend growth of others typically sell at yield spreads that are larger than the current yield spreads between MLPs and their GPs.] The GPs of the big caps to some extent have been stress tested in 2009 and survived that test. So they deserve to sell at lower yields than their MLP partners - and one can put more faith in a distribution growth projection going forward due to 2009's stress test. The first three of my ten suggestions are GPs: BGH [liquids], EPE [NGLs and natural gas, crude and refined products] and NRGP [mostly propane with some natural gas storage and gathering assets]. Be cognizant that GPs carry some additional legislative risk since they hold no physical assets and could be impacted more directly by potential tax law changes. This is not probable, but possible.
      If one wants to lessen this legislative risk - drop EPE and buy EPD. The GP/MLP spread on distribution growth has been better with BGH than EPE. And your portfolio may want propane exposure - and propane GP NRGP has been the star of distribution growth. Inflation risk scares me much more than legislative risk - so I [with my unique mix of fear and greed] would not suggest dropping down to only one GP. I would not suggest dropping down to two.

Buy Four Midstream MLPs
     
Staying with midstream MLPs, I would then buy four from this list: BWP, EPB, GEL, MMP, SEP and SXL. This is the meat of ones MLP portfolio where I choose to suggest safe MLPs with better than average CAGRs [for those that get them, see that spreadsheet below] and superior distribution histories [see that spreadsheet below].

Natural gas based BWP has 14,000 of natural gas pipelines in 12 states with almost 100% of the pipes being FERC regulated which carry natural gas long distances. BWP has 160Bcf of gas storage capacity. One down-side - BWP has had execution problems on recent organic growth projects, with some pipeline anomalies delaying start-up and 45% cost overruns. Ending January 2010 with a 6.72% yield, it is close to fully valued on that metric. The bulls on BWP will say its problems are behind them and they are ready to harvest big gains in EBITDA over the next few years from recent cap ex projects. The bears will worry about the trend of BWP having problems with execution.

Liquids based GEL transports crude oil, CO2, and natural gas, does some processing of sour natural gas, and does terminaling, blending, storing, and marketing of petroleum products. Denbury Resources (DNR) has recently sold its general partner interest in GEL to Quintana Capital Group, an energy-focused private-equity firm. Denbury will continue to own approximately 10% of GEL's common units [DNR acquired the GP for E&P MLP ENP]. Quintana owns a sizeable portfolio of energy investments which it can drop down to GEL. GEL's superior distribution growth was a byproduct of its huge distribution coverage ratio, which should be the source of higher than average distribution growth. Two down-sides - [1] GEL’s operations is dependent on DNR’s ability to supply oil and CO2 volumes; [2] Quintana may drop down marine transit assets to GEL. GEL grew its distribution 9.30% in 2009 and enters 2010 with a very low 71.57% distribution/DCF ratio.

Liquids based MMP transports, stores and distributes refined petroleum products. MMP is now an LLC, so the absence of IDRs [MMP is the only investment grade MLP without IDRs] should assist forward distribution growth. Distribution growth prior to 2009 was above average. And MMP has historically given distribution guidance in their Q4 calls.

Liquids based SXL transports crude, does a lot of storeage, and transports refined products. SXL was picked due to its superior distribution history. Distribution growth tends to have inertia. And SXL's changing or pushing out of its threshold before it hits the 50% IDR mark will aid in continued distribution growth. Added to that, SXL has strong distribution coverage, above average CAGRs, and a very low [2.5x] debt/EBITDA ratio.

Natural gas based EPB or SEP are 'drop down' MLPs with big parents [or GPs], and comparative MLP newbies low in their IDRs. So their distribution growth should continue to be noticeably above average for the next few years. SEP transports and stores natural gas. SEP's GP is Spectra Energy. SEP has great distribution coverage, a recent history of superior distribution growth, and high CAGRs.

EPB does natural gas transportation and storage. El Paso [EP], the GP for EPB which owns 67% of the LP units, is the largest operator on interstate natural gas pipelines in North America. Average contract life is six years with close to 90% of its capacity done in demand charges - thus EPB has very stable cash flows. EPB's exposure to growing supply sources in the Rockies and expanding markets in the Southeast provide it with attractive expansion projects.

One will probably want to weight their portfolio more towards natural gas [because the U.S. demand for gasoline may be flat going forward for a few years]. So weight your selection of these six with at least 50% natural gas MLPs. I would suggest a four natural gas to two liquids ratio. But being 100% in natural gas on this second group of sugestions would not be a bad thing, if you have BGH and EPE as your GPs.

If one wants to invest via an IRA and know that UBTIs will never be a problem - then I would suggest KMR - and I would suggest that one skip lower growth EEQ. [And if you do not want immediate yield from all of your investments, then KMR (with its discount to KMP units) not only is a better selection than KMP, it is a good selection compared to most other midstream MLPs] If one buys KMR, cut one from the suggestions already made. KMR is a hybrid natural gas and liquids MLP - and do not over weight your liquids.

By now you should have six selections, from the suggestions listed above, when making a 10 MLP/GP/G&P/E&P portfolio.

Have 10% of Your MLP Weighting in E&P

With the 4 choices left - I want some strong growth potential or some higher than average yields. And one of them [or 1/10th of the portfolio] should be an E&P to have exposure to that very different sector. Even though I have watched the E&Ps for three years - I have not listened to the earning calls. And their valuations are based on metrics I do not follow [like the value of their hedges and price/NAV ratios]. So they are outside the area of my expertise. It is best to follow the suggestions of others on E&Ps. If I wanted an E&P today - I would buy two of these four [and give the two a 0.5% weighting]: EVEP, LGCY, LINE or PSE. That decision is based on their distribution histories. [All other E&Ps failed their stress test in 2009.] ENP has a flexible distribution policy - making it a unique hybrid between a typical MLP and a royalty trust - and is worth a look. But remember - I lack confidence in my E&P suggestions - and hope that others will add replies to this thread sharing their knowledge E&Ps while giving metrics to justify their suggestions.

Buy Three G&Ps - or Have a 30% Weighting

And that leaves us with three investments left from the G&Ps. And I suggest, and like [and own units in] MWE and RGNC. WES is my third [and safer] suggestion. I like and own units in KGS and list it as an alternative selection - but KGS comes with some warnings.

MWE is a GP-less LLC - and I like the idea of it not having IDRs and a lower cost of capital. I liked MWE's history of distribution growth prior to 2009 - and project a moderate return to that growth in 2011. And I really like MWE's exposure to the Marcellus. MWE's number one source of molecules in the Marcellus is Range Resources [RRC]. Chesapeake and Statoil are also sources. MWE's source of molecules in the Woodford and Granite Wash is Newfield Exploration Company [NFX]. MWE has a forward CAGR of 2.5% partially due to the expectation of no distribution growth in 2010 and slow growth in 2011. MWE may be hyper-sensitive to rising interest rates or a second credit crunch. Example: It sold debt in the 11s in mid 2009. And MWE may continue to do secondary offerings more often than the average MLP due to the need to raise capital for aggressive growth cap ex budgets.

RGNC is a spin-off from private investor firm Hicks Muse with the GP now owned by GE Energy Services [it has a strong parent] from which assets are dropped down in addition to its growth cap expenditures, and has significant Hayneville exposure [it has a great geographic footprint]. RGNC has a forward CAGR of 4.0% partially due to the expectation of low distribution growth in 2010. RGNC's current debt/EBITDA estimates are in the 5's - so it is a good thing it has a strong parent and that forward EBITDA estimates are higher. [From an unnamed source: $206 million in 2009; $296 million in 2010, and $375 million in 2011.]

WES is drop the down MLP for $32.39 billion market capped Anadarko Petroleum [APC] with assets in East and West Texas, the Rocky Mountains and the Mid-Continent (they are drilling in the country) that has 90% fee-based revenues. WES' debt to book cap = 21% (very low) and the debt/EBITDA estimates are in the 2s. WES has a forward consensus CAGR estimate of 5.7% [and the better analysts rate it even higher]. It is the combination of these two indicators of safety, added with the current distribution growth [this G&P grew distribution in 2009 by 6.67%] and higher CAGR projections, which results in the market giving WES such a low yield. It deserves it. WES gets [depending on the quarter and depending on the source of the information] between 70% and 90% of its molecules from parent APC.

KGS could be substituted for MWE or RGNC if you value the 'fee based' attribute. But KGS has its own risks. KGS is the drop down MLP for $2.64 billion market capped Quicksilver Resources [KWK] with assets only in the Barnett Shale (they are drilling in suburbia) that has 90% plus fee based revenues. KGS' debt to book cap = 79%. KGS has a forward CAGR estimate of 7.0%. KGS gets almost all its molecules from parent KWK - and that lack of client diversification and geographic diversification makes some investors nervous. I strongly suspect that this worry is already included unit pricing. This may not be a good 'newbie' MLP, because you need to keep an eye on it and KWK for potential trouble. On the 'pro' side of the ledger - KGS grew its distributions in 2009 by 11.43% and looks very full of potential for more drop down acquisitions from KWK. KGS' gathered volumes are projected [by KGS] to more than double from the projected 2009 level.
 
In 2008 it was hard for me to suggest a portfolio of less than 10. In a world that was falling apart, I at least wanted diversity to give me comfort. Today I could cut that diversification need to only seven: EPE, NRGP, EBP, MMP, MWE, RGNC and WES. And if you have less confidence or comfort in the three G&Ps, then partially cut your weighting in them to the point where you find comfort. Sleep is more important than growth.

The 2008 edition of the 'suggestions' portfolio of 10 had 30% in GPs - 30% in mostly big cap safe MLPs - 30% in G&Ps - 10% in E&Ps. That mix still fits me - but it may not fit others due to lack of exposure in two other MLP sectors. I have never purchased units in a shipper [mainly due to distribution eliminations at USS - an event recently echoed with KSP and OSP]. Shippers operate on different metrics - and I lack familiarity with them. There are too few coal MLPs for me to get a sense of what price and distribution changes were due to good management and what changes were due to commodity pricing.

I still do not like any MLP CEF. I did not like their asset allocations [they were too low on GPs and G&Ps]. I did not like the lack of distribution growth back in 2008 when I first wrote 'Suggestions' - and the distributions for all but one SHRANK it 2009. I did not like the complexity of their credit metrics and assets coverage ratios; or the concerns about forced assets sales due to redemptions when there are asset coverage problems. But most of my investing is done outside an IRA - so that changes my needs. An IRA investor may want to suffer these CEF set-backs and short-comings in order to gain the certainty of knowing there will never be an UBTI problem.

Why choose a 10% allocation? It does not make much sense to me for one to learn the handling of K-1's and the tax differences; and follow the sector - keeping up with the news, events and opinions, if one is choosing a weighting for the sector under 5%. Successful MLP investing is labor intensive compared to other investment options. It does not have to stay that way. Some MLPs may well be buy once and hold forever investments - where are all you need is a once per quarter update on their performance. And if you turn your taxes over to a CPA, you can cut down on some of the learning process via delegation.

Why not an even higher weighting? These suggestions are for newbies. Give them a year or two before they jump in with a more heavy weighting. Even if they were to follow my suggestion to the letter, there will still be winners they missed and losers they purchased [both events being caused by changes in DCF projections].
    
Why the focus on high CAGR MLPs? [1] This is due to the expectation that a large part of the targeted audience for this message - probably older than average investors with an age appropriate heavy weighting in bonds - will need a strong growth component in their equities. A younger newbie, or someone with smaller holdings in bonds, would not need this high CAGR focus. [2] Growth sells at a discount because it is uncertain. It is my expectation that growth is more certain in this sector than in others due to: some inelasticity in demand for these services; some monopoly like attributes in these services; and that fact that growth continued in many parts of this sector, even in 2009.

This investor is influenced in his MLP selections by choices in his non-MLP portfolio. I get diversity by having 65% of my investments in conservative mutual funds [mostly in American Funds family equity funds - with a large share in non-US and non-energy investments from those funds]. I do not have a heavy energy component in my portfolio outside of MLPs - and that gives me more comfort in having a 20% weighting in them. Your allocation decision in MLPs needs to be adjusted based on your non-MLP portfolio of energy stocks. I own mostly safe equity REITs and growth regional banks and I have been rewarded by choosing safety and growth over yield in those sectors. One's success with investment A leads one to buy investment B. One's disappointment with investment C leads one to shun investment D. One's safety and comfort in investment E might give one more freedom to take risk in investment F. The above MLP suggestions probably uniquely fit someone with my interests and needs and psychology.

If you are buying MLPs mainly for the yield, then do not ignore . . .

Lightly buying BDCs

There has been a lot of huge amount of dividend cuts by almost every BDC in 2009 - but three BDCs did not cut: MAIN, TAXI and TCAP. And there are two BDCs that have cut the divs, but the quarterly net investment income [NII] to quarterly dividend ratios are atypically strong: BKCC and NGPC. That metric is an indication that the current dividend is relatively secure and likely to increase. My weighting in this sector is under 2% - and IMHO any weighting at or over 5% is crazy. But a 2% weighting in stocks that have such huge yields goes a long way. If you can not track NII/share metrics and the debt per share to NAV ratio, then you lack the skills to safely invest in BDCs.

Moderately buying REIT preferred shares

While REITs have also cut their dividends in a major way - I am not aware of any preferred shares having dividend cuts or suspensions. Even after a great 2009 [in unit price appreciation], one can still get 8% yields in preferred REIT shares. If you can track debt/market cap, debt/EBITDA, interest coverage ratios, fixed charge coverage ratios, and debt maturities, then you have the skills to invest safely in REIT preferreds. And if you can tell a strong balance sheet from a weak one, then this is a fair sector in which to buy bonds.

Invest in individual bonds in the sectors you know

Ignore this suggestion if you have never purchased an individual non-muni bond. But . . . . Most of you have bond funds. And that is the way to get most of your exposure to the bond asset class. But if you know MLPs, then do not overlook buying some MLP bonds in the mostly large capped companies with good histories. Your knowledge and comfort with MLPs can make their bonds uniquely more valuable to you than investors in general. But this suggestion is far those with larger portfolios who can buy in bulk and to someone who already has a good broker you trust to help and guide you. If one buys bonds - then it is probably best for the retail investor to buy on the day the bonds are newly offered in the expectation that bid/ask spreads are lower then. Never do the equivalent of a market order. Check the pricing at www.investinginbonds.com so that you see that small investors can [and often do] get screwed on the pricing of what bonds they buy. So if or when you do this - it is best to name your bid and wait for days to see if it gets a bite. I have never purchase an MLP bond. I am aware of some potential problems - and they are listed above. There could be more downsides than this. Do not make an MLP bond purchase your first bond purchase.

A brief section on the why not's

There are a lot of MLPs which did not make the suggestion list - and any good newbie should be asking 'why not KMP', or some other MLP failing to make the list. My brief answers for the big caps are below. The answers apply for those buying an MLP today. If you are still a newbie who bought one of the following six months ago, then the fact that one has a high or unwarranted price/DCF today would not be a reason for you to sell it today.

Company - Reason
BPL - Look at the relative distribution growth for its GP. Buy the GP.\\
DEP - One gets DEP exposure via EPD or EPE. Buy EPD or EPE.\\
EEP - Slow prior distribution growth, with low CAGRs.\\
ETP - 50% IDRs with slow distribution growth and a management that can't close a deal.\\
KMP - 50% IDRs, average CAGRs, with too high a price/DCF for a better than average MLP.\\
OKS - Too high of a price/DCF for average distribution growth and average CAGRs.\\
PAA - No reason not to buy it. But it is expensive for a better than average MLP\\
NS  - No reason not to buy it. But it is expensive for a better than average MLP\\

Acronyms used in this message
BDCs - Business Development Companies - loan to companies too small to be publicly traded, big dividend payers, risky
CAGRs - Compound Average Growth Rates - from most analysts, the projected growth in the distribution over next 5 years
DCF - Distributable Cash Flows - good substitute metric for earnings
EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortizations - number used in credit metrics
E&Ps - Explorations and Production Companies - companies that drill and get molecules from the ground
IDRs - Incentive Distribution Rights - as the distribution rises, the GP receives more of the cash flows
GPs - General Partners - they own the IDRs
G&Ps - Gathering and Processing MLPs - they take molecules to processors that split NGLs from natural gas
LLCs - Limited Liability Company - they do not have a GP
NPAs - Non-performing Assets - loans where the borrower is not making payments + repossesed assets
REITs - Real Estate Investment Trusts - historically good dividend payers

Don't Stay a Newbie - Read the Primers

The MLP Primers that are publicly available:
From Wachovia - http://www.naptp.org/documentlinks/071508wacoviaprimer.pdf
From Alerrian - http://www.naptp.org/documentlinks/ACM_MLPPrimer.pdf
From Merrill Lynch - http://www.naptp.org/News/Weeklyupdates/MLMLPGuide.pdf
From Raymond James - http://www.naptp.org/documentlinks/RaymondJamesGuidetoMLPs.pdf
. . and the too short to be much help primer from S&P - http://www2.standardandpoors.com/spf/pdf/index/MLP_Primer_Nov2008.pdf

If this message has been of use to you, then please return the favor by joining in the efforts to solicit better credit metrics reporting and more DCF/unit reporting of MLPs in the week before their conference calls.

My thanks again to passandshoot, fyrisle, Fugitive Pauper, chamois16, mplaut, sophistabubba, stockmasterflash, vireya and BeholdNebuchadnezzar - all of whom have sent in comments and suggestions to earlier drafts of this message.

Bob a.k.a. Factoids

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