The S&P 500 declined 6.9% in October as expectations for 2019 earnings comparisons downshifted. With 2018 earnings up 22% and the approaching anniversary of The Jobs and Tax Act of 2017, earnings comparisons will soon compare against tax cut enhanced earnings, and likely drop back to the normal 10% yr./yr. growth. Along with a contraction in monetary stimulus by the Federal Reserve, causing a material increase in interest rates, a correction was due. The combination of rising interest rates and decelerating earnings are fundamentally negative for equity market valuations. This correction, however, creates the opportunity to add to select equity investments.
The Fed Model:
Given the unprecedented global central bank financial accommodation in response to the Great Financial Crisis, the most logical equity valuation methodology remains the risk premium also known as “the Fed Model”. The risk premium compares bond yields to the S&P 500 earnings yield. Currently, the risk premium is 3.3%[efn_note]S&P earnings yield for 2019 = 176.96/2711.24 = 6.52%. 10-year US Treasuries yield 3.15%. The Risk Premium is the added earnings yield investors are paid to own the S&P 500 over the 10-yr US Treasury bond. 6.52-3.15= 3.37 the current Risk Premium is 3.37%. When this number drops below zero, the stock market is an unwise or poor value compared to bonds.[/efn_note] and comfortably above 0%. Since 1999, when the trend in earnings is overlaid on the Fed Model, risk premium has been effective in calling major turning points in the US equity market. The historical chart below shows that current rates still are not compelling competition to equities. With earnings still increasing, the equity market remains an attractive risk.
Shiller CAPE Model:
Based on the S&P 500’s forward price to earnings multiple of 15.32[efn_note]15.32 = S&P 2711.24/176.96 Est. S&P earnings for 2019[/efn_note] the stock market is not over-valued. If it were not for the low-interest rate environment, the Shiller CAPE[efn_note]Shiller’s CAPE is The Cyclically Adjusted Price Earnings (or PE over the last 10 years of earnings).[/efn_note] multiple of 30.60 would indicate significant potential downside risk. The chart below of the Shiller CAPE multiple shows that it is near 1929 peak levels. The current low-interest rates environment, the reasonable forward market multiple and positive earnings momentum together suggest select equity investments can be made.
With 10-year US Treasury yields at 3.15%, there is a good historical basis to expect interest rates to rise. If the Federal Reserve fully unwinds its unprecedented accommodation, 10-year US Treasury yields could easily rise to 6% and that could be disastrous for equity markets and the economy. Consequently, the Federal Reserve still has an enormous challenge to manage.
Inflation Risk to Interest Rates:
If inflation were to accelerate, interest rates could start rising rapidly and quickly unravel the whole market. While technology continues to keep inflation low, healthcare, education and energy prices continue to rise. Fortunately, the strengthening dollar, driven by tightening US monetary policy, has had a depressant effect on inflation. The deflationary benefit of a rising dollar will end as this tightening cycle ages and other central banks begin to tighten. When the dollar peaks, inflation could accelerate, and rising US Treasury rates could accelerate potentially unwinding this equity bull market. Consequently, we believe 2020 is the year when this equity market peaks as US Treasury yields are heading toward 6%.
As 2018 comes to an end, commodity performance is outperforming stocks and bonds. Consequently, we are adding to gold, energy and other hard asset investments to diversify. Energy looks particularly robust, but all commodities should do well as the emerging markets begin to recover with the inevitable end to the global trade negotiations being promoted by the US administration.
Master Limited Partnerships were a wonderful investment vehicle providing stable total returns for investors for the last 20 years. MLPs offered investors high growing distributions that were tax-advantaged and provided needed capital that financed the buildout of the US midstream energy infrastructure. The relationship between the General Partner (GP) and the Limited Partner (LP), appeared to be a symbiotic structure where the LP holders benefited from the GP’s management skill and the LPs provided the capital for the entity’s growth.
The relationship has now become more complicated. Structures with Incentive Distribution Rights which benefited the GP, began to undermine that GP-LP win-win relationship. Several transactions have led to a restructuring of the GP LP structure which led to unpleasant tax consequences for some LP holders. The restructuring of several GP-LPs has made the MLP space, still suffering from the 2014-16 oil bear market, difficult and frustrating.
Nothing, however, compares with the experience of American Midstream Partners LP (AMID) unit holders – AMID is our largest MLP position. We had bought JP Energy Partners LP (JPE) and AMID at the bottom of the MLP cycle as they were deeply oversold and positioned to rebound with the cyclical recovery. Both entities tripled in price and then merged making AMID heavily over-weighted in our portfolios. One feature I liked was that AMID had ArcLight Capital Partners, LLC as a sponsor and had provided capital to AMID to support its distribution during the downturn. ArcLight is a major private equity firm that has invested $21 billion in energy assets.
Unfortunately, on July 27, 2018, AMID cut its distribution 75%, and its units dropped from $11.35/unit to $5.21/unit in the days following the distribution cut. The lack of timely real-time public disclosure of material corporate actions is particularly noteworthy. Neither the day of nor following the July 27th press release of the distribution cut and significant business strategy change did management arrange a conference call to explain their dramatic action which left common unitholders panicked and confused. Volume rose to 20 times the monthly average. By contrast, on their Q3 conference call November 7th, 2017 CEO Lynn Bourdon said “As we sit here today, just about 90 days from when we held our last earnings call, what we have achieved is significant. These accomplishments underscore the support that we have had and can expect from our sponsor ArcLight Capital Partners, as we move forward.” And “Quite frankly folks, this train is leaving the station. I hope as investors, you are as excited as we are about our future and if you stay with us or you get on board quick, because we have an exciting and successful journey ahead of us, and we’re not waiting around.” Was management’s silence intended to depress the price of the stock or change the shareholder base in order to benefit ArcLight’s later buyout bid?
By mid-August, I finally got a return call from Lynn Bourdon, CEO, joined by Eric Kalamaras, CFO and IR Mark Schuck and they explained how this distribution cut gave AMID additional cash flow to grow the company and they had an $800million “wedge” of attractive investments they sought to integrate. When combined with:
- the sale of the Marine products terminal for $210mm;
- the cancellation of the Southcross deal;
- the Moody’s upgrade;
- the agreement with industry giant Enterprise Products Partners, LP, to optimize their Gulf Coast Assets;
The new business plan offered significant upside to recoup the capital loss resulting from the distribution cut. We investors just needed to be patient and give management time to implement the new strategy. That did not happen.
On September 28, 2018, ArcLight Energy Partners Fund V, L.P. (“ArcLight”) bid $6.10 for AMID. ArcLight owns 90% of American Midstream GP which manages AMID. This bid seems grossly undervalued by our analysis and, according to Houston based Recurrent Advisors[efn_note]Bloomberg, October 10, 2018, Rachel Adams-Heard Columnist Authored: Investor Slams Pipeline Governance as It Seeks to Halt Deal. Egregious was reported by a large institutional holder who read the actual letter.[/efn_note], is “egregious”. More troubling are the winners and losers from this action. ArcLight is a sophisticated institution that is benefitting from the structural mispricing resulting from the 75% distribution cut that its 90% owned GP–American Midstream GP LLC–just authorized. This bid allows ArcLight to buy AMID’s midstream assets at fire-sale prices and position ArcLight Energy Partners V to handsomely profit from the opportunity the CEO Lynn Bourdon emphatically sold to its LP investors–who were likely unsophisticated and retired–at double the price.
Midstream energy assets are durable income generating investments. The value of AMID’s assets did not suddenly drop 50% on July 27th. AMID’s cash flows did not drop either. ArcLight knows the value of these assets with its exceptional access to valuation resources and data from its energy private equity business. Owners of AMID LP units are likely elderly investors who do not have the detailed financial reporting and analysis created for operations, sophisticated corporate valuation tools and the asset value data that ArcLight has. The lack of a conference calls following the 75% distribution cut and following insider ArcLight’s $6.10 bid; AMID’s unwillingness to publicly comment on the fairness of the bid and the likelihood that CEO Lynn Bourdon will be soon employed by ArcLight all seem to suggest AMID’s behavior benefits ArcLight to the detriment of AMID unitholders. Isn’t this what corporate governance and fiduciary rules are designed to prohibit?
I wrote to the CEO, Board of Directors and conflicts committee of American Midstream. I asked them to publicly reject the bid and to ask ArcLight to not bid for the company for another 12-24 months.
I did not get a response to my letter nor was I granted the opportunity to speak with the conflicts committee regarding my concerns. The economic discount ArcLight’s bid is priced to capture could be on the order of several hundred million dollars. This seems unfair and unjust, and is another blow to MLPs and capitalism.
Tyson Halsey, CFA