DNAmarkets

Friday, April 13, 2012

Update on Master Limited Partnerships

On April 12, 2012, I was on a conference call with Swank Capital for an update on the Cushing 30 MLP Index. The following are a few highlights:

- MLP as an asset class as of 3/31/2012 has a market cap of approximately $350 Billions

- An additional $250 billions may be needed to build infrastructures by 2035

- Based on the Cushing 30 Index the spread between MLPs and 10 year US Treasury is at 420 basis points; a spread over 400 points historically has forecast a very positive 12 month forward return for he sector. I calculate the spread using the Alerion Index and we are not quite at 400 bips but close enough (373)

- While Nat gas prices remain nvery low, spreads and margins continue to be attractive for MLPs that process and transport Natural Gas Liquids

- Domestic onshore Crude Oil development possible new area of expansion for E&P companies

- Growing supply of shale gas and declining supply of conventional resources are changing the pipeline blueprint

- MLP Subsectors Nat Gas, Propane and Coal continue to underperform while Shipping ad Transportation continue to outperform. Significant dispersion of returns among the subsectors is expected to continue

- M&A trend should continue

Disclaimer: PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THEREFORE, NO CURRENT OR PROSPECTIVE CLIENT SHOULD ASSUME THAT FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT AND/OR INVESTMENT STRATEGIES MADE REFERENCE TO ABOVE AND RECOMMENDED OR UNDERTAKEN BY CERVINO CAPITAL MANAGEMENT, WILL BE PROFITABLE OR EQUAL THE CORRESPONDING INDICATED PERFORMANCE LEVELS. DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT ANY SPECIFIC INVESTMENT WILL EITHER BE SUITABLE OR PROFITABLE FOR A CLIENT OR PROSPECTIVE CLIENT'S INVESTMENT PORTFOLIO. HISTORICAL PERFORMANCE RESULTS FOR INVESTMENT INDICES AND/OR PORTFOLIO BENCHMARKS DO NOT REFLECT THE DEDUCTION OF TRANSACTION AND/OR CUSTODIAL CHARGES, THE DEDUCTION OF ADVISORY MANAGEMENT FEES, NOR THE IMPACT OF TAXES, THE INCURRENCE OF WHICH WOULD HAVE THE EFFECT OF DECREASING HISTORICAL PERFORMANCE RESULTS.
HYPOTHETICAL RISK DISCLOSURE: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN, IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Thursday, April 5, 2012

Update on Exotic Fixed-Income

A while ago I commented on the expanding opportunities in Emerging Markets Corporate Credits as our domestic fixed income market looked increasingly less attractive; this exotic fixed income update wants to highlight the specific Asian segment as a potentially attractive idea.

The Asian bond market can be attractive in terms of Sovereign issues and Corporates as well; the credit quality of many Asian Sovereigns has improved dramatically over the years and it is backed by large current account surpluses. Especially when compared to the Euro Sovereigns and the highly expensive US Treasuries, Asian Sovereigns seem to deserve attention. This is not to say that they are risk free as this concept is becoming increasingly disconnected from the old fashion definition of government issued securities anywhere in the world. Teresa Kong of Matthews Asia reports significant increases in liquidity, transparency and diversification in the Sian bond market.

An exposure to international bonds carries an additional element to the investment; the position will be affected not only by the general level of interest rates, credit changes and liquidity but also currency exposure. Exposure to different currencies is a new element of smart diversification that at least large portfolios should consider. Teresa Kong of Matthews Asia makes a good point when she states: “If one were to think of investments as a way to generate income to cover expenses over the long term, having a proportion of income denominated in the same currency as future expenses might act as a currency hedge. Given that Asia accounts for an increasingly larger portion of U.S. imports, having an income stream derived from underlying instruments denominated in Asian currencies might be prudent.”

The higher yield and the diversification effect do come with a price: a higher level of volatility when compared to US bonds. However, Asian fixed income carries half the volatility of US equities and roughly one third of the volatility of Asia Ex-Japan equities (source: Matthews Asia).

Trading Master Limited Partnerships

This is an excerpt from an article written for Active Trader Magazine March 2012 Issue

Introduction to Master Limited Partnerships

Diversification, high income, tax efficiency, lack of correlation to traditional asset classes; these four elements would seem to be the pillar of every well designed investment vehicle. Master Limited Partnerships (MLP) have delivered just that for the last decade. But what is exactly an MLP? They are publicly traded, limited partnerships which own and operate gas and oil pipelines, storage terminals and refineries. They are structured like partnerships to take advantage of favorable taxation and to create income focused investment vehicles.

MLP have over the years concentrated in sectors related to energy but unlike their earlier versions of the 1980s which were structured solely for the purpose of exploiting tax loopholes in the oil and drilling area, these new partnerships have become efficient and dynamic utilities. They have acquired cheap assets with predictable cash-flows like pipelines and terminals and became very good at operating them.

These investment vehicles retain only a mild correlation to the price of oil and gas since they care mainly for its transportation. However, as the economy grows and demand for energy grows with it, the profits of the MLP increase accordingly. MLP also offer protection against inflation in two ways: via their portfolio of real assets and via “inflation-plus pricing,” or in other words their ability to price their services and products at a premium of the PPI rate.

Due to the partnership structure, MLP generally do not pay income taxes eliminating the problem of double taxation of dividends that corporate investors face. MLP generally pay out all available cash flow defined as cash flow from operations less maintenance capital expenditures in the form of quarterly distributions. Additionally, limited partnerships receive a tax shield equivalent to 80-90% of their cash distributions every year. This allows an investor to pay income taxes only on 10% to 20% of the distribution received. The rest is deferred until the investor sells the security. This tax deferral reduces the investor’s tax basis in the partnership unit. Because of these reasons, MLP seem perfect for estate planning.

There are different risks associated with this type of investment. The first would seem to be the competition MLP face from other fixed income products. As interest rates in general increase, so must the rate of MLP’s distributions, otherwise a price correction will occur. Generally MLP are priced to yield anywhere between 6% and 10% depending on the level of risk associated with each utility. Accordingly to Wachovia Securities research, movements in interest rates explain approximately 25-30% of MLP price changes.

Additionally, like in every company, macro-economic performance and management execution are important elements in the valuation process; therefore distributions could vary depending on such factors.

While one of the main elements of attraction is the tax efficiency enjoyed by the MLP, such advantage could be erased by a hostile Congress.

MLP may have some restrictions for IRA accounts. While they can be held in such accounts, MLP should not generate more than $1,000 per year in UBTI (Unrelated Business Taxable Income) or the exceeding income would be subject to taxation.

Trading Master Limited Partnerships

MLP are usually considered long term investments generally included in an income oriented portfolio. Their large distribution and the consistency of growth of such pay-outs made the sector a staple of passively managed portfolios. However, the combination of today’s low rates of returns for most asset classes, MLP consistent total return outperformance and an increase in the sector volatility should make them interesting for more active investors as well.

Master Limited Partnerships (and we focus on energy related names which comprise the large majority of this universe) are divided in 10 subsectors which cover the whole spectrum of the energy chain – upstream, midstream, downstream – with a concentration of companies in the midstream sector (transportation, storage, refinery).

There are different indexes that allow monitoring of the performance of the sector in aggregate but the two main benchmarks are the Alerian MLP Index which is made of 50 MLP and it is cap weighted and the Cushion 30 which includes 30 MLP and it is equally weighted. It is important to note that in the Alerian Index, the five largest companies represent over 40% of the index.

MLP have provided an annualized total return of approximately 20% in the last decade (there are small differences depending on the Index used) and even when expanding the historical analysis to a longer time horizon, the total return does not vary much. A large portion of this performance clearly comes from distributions which have averaged anywhere between 6% to over 7% depending on the benchmark. The current distribution level, its expected rate of growth and how it compares to alternative income sources is a traditional way to determine value in the sector and trigger trades. Classic comparisons are run against the US Treasury 10 year note, REITs and BBB bonds. The average spread over the 10 year Treasuries is at 321 basis points and we are today at a 413 point spread (this is based on the Cushion 30 Index, when looking at the Alerian Index the spread seems to be a little lower than 400 points). Spreads over other income products are also above their historical norm as of this writing; the average spread over REITs is approximately 190 basis points and we are now trading at 241. The spread over BBB bonds is on average at 129 basis points and it is now at 162. Spreads over 400 basis points versus Treasuries have consistently shown a positive forward returns for MLPs. Normally this metric tends not to exceed 500 basis points but it did experience an aberration of 1200 points during the 2008 credit crisis climax. Spreads at around 200 basis points are generally precursor of underperformance.

Another valuation metric typically used for MLPs is Current Price over Distributable Cash-flow; such metric now stands at 11.6 times which is line with historical fair value (source: Swank Capital)

As mentioned in the introduction, another useful trait for this sector is the lack of correlation to stocks and a mild correlation to energy prices. Correlation to stocks did increase during the 2008 crisis as the result of most asset classes increasing correlations and because the core of the crisis generated from the credit market which is vital to this sector. As far as correlation to oil and gas, the degree varies depending on the subsectors but overall there is more correlation to GDP than to spot crude. The following table shows individual correlation to oil and gas for some of the most common names:

	APU	BPL	EEP	EPD	FGP	KMP	MMP	NRGY	NS	PAA	SPH	SXL	TCP	NAT GAS	CRUDE
APU	1
BPL	0.404	1
EEP	0.449	0.444	1
EPD	0.42	0.296	0.4	1
FGP	0.48	0.315	0.332	0.387	1
KMP	0.487	0.373	0.493	0.383	0.264	1
MMP	0.376	0.422	0.5	0.371	0.241	0.425	1
NRGY	0.38	0.508	0.54	0.367	0.323	0.324	0.603	1
NS	0.374	0.524	0.471	0.373	0.227	0.371	0.615	0.675	1
PAA	0.414	0.289	0.445	0.384	0.273	0.286	0.44	0.475	0.43	1
SPH	0.617	0.256	0.462	0.473	0.416	0.434	0.466	0.502	0.516	0.4	1
SXL	0.344	0.427	0.409	0.273	0.164	0.295	0.505	0.555	0.544	0.357	0.432	1
TCP	0.431	0.256	0.465	0.413	0.351	0.229	0.291	0.35	0.361	0.27	0.448	0.251	1
NAT GAS	0.068	-0.06	0.069	0.116	-0.015	0.186	-0.002	0.038	0.039	0.031	0.087	0.031	-0.013	1
CRUDE	0.061	0.105	0.234	0.172	0.154	0.059	0.013	0.093	0.014	0.057	0.002	0.01	0.2266	0.24262	1

As indicated previously, MLP in aggregate also show mild correlation to other asset classes at 0.49 versus the SP500 and 0.35 versus REITS (Source: Swank Capital). One caveat, correlations can change and depend largely on the time period chosen.

It is also important to remember that while most analysis is generalized by looking at aggregate numbers, the MLP universe, as I mentioned earlier, is represented by 10 different subsectors which may show significant delta in their performance. Trading opportunities surface regularly by evaluating subsectors against each other. As an example, last year the best subsector was General Managers while the worst one was Natural Gas Storage; the performance delta was a significant 60%. The following is a list of the available subsectors:

- General Managers

- Natural Gas Gatherers and Processors

- Refined Products Pipelines and Terminals

- Natural Gas Transportation

- Crude Oil Transportation,

- Upstream

- Shipping

- Coal

- Propane

- Natural Gas Storage

As investors’ interest in the space has grown over the last few years, more investment vehicles have also come to market. While it is usually a much better trading proposition to utilize individual MLP (unless there is a need to avoid the additional tax reporting complication of a K-1), some Closed-End funds may offer arbitrage opportunities. Closed End funds can trade at a premium or discount to NAV and can therefore provide additional opportunities to extract value.

Conclusion

There are many fundamental factors that will increase active investors’ interest in the MLP space. The sector has now a market cap of $325 billions and it is estimated that another $250 billions will be needed by 2035 just to service and distribute the existing energy reserves. The evolution of the natural gas story after the large reserve discoveries in the United States will offer many opportunities in the future. Additionally, Merger and Acquisition activity should continue to provide arbitrageurs opportunities to participate in the consolidation trend.

Enough to keep everyone interested!

PS Tables calculations provided by Rosario Rivadeneyra

Friday, February 3, 2012

Gold: A Solution for Zero-Beta Satellites

In a previous piece, I illustrated a more active approach to core-satellite portfolio construction. While managing the core in a pro-active way mostly deals with fine tuning a multi-beta exposure and then applying active risk management, more creativity can be utilized for the satellite.

In this regard, there are probably two main approaches: active alpha or crisis alpha. The first would require a strategy geared toward exploiting market anomalies that may lead to superior performance; such outperformance may realize itself via concentrated and targeted bets or via uncorrelated performance when measured over a certain timeframe. On the other hand, the latter would implement a strategy not only generally uncorrelated to the traditional core but that would be able to produce superior performance especially during times of great stress for traditional asset classes.

This is an important distinction often overlooked: alternative investments which are usually generalized as a solution for alpha exposure may provide superior performance (especially over longer time frames) but not necessarily at times of significant liquidity and credit breakdowns for traditional asset classes. A detailed factor analysis may uncover superior returns for many alternative strategies; however, it may also reveal a degree of sensitivity to fundamental price drivers common to traditional assets which may be much higher than desired. Only a few strategies seem to be providers of crisis alpha or outperformance in time of significant stress in traditional betas: gold seem to fit that definition.

The successful run of the precious metal in the last ten years has been sparked by a confluence of positive factors such as extremely easy global monetary policy and a socio-economic transition from an age of optimism to a zero-sum era. These elements reversed a downward trend in gold entrenched since the famous top in the early 1980s. Central banks have been reversing their selling course as well as they relaxed their monetary policy.

This new dynamic rendered gold a stronger candidate for portfolio allocation. Gold ability to provide crisis alpha makes it a perfect asset for inclusion in a zero-beta satellite.

Gold does not produce a stream of cash-flows which makes it difficult to analyze it based on classic valuation metrics such as DCF models, leaving most of the analytical work reliant on the study of supply and demand. However, as the metal increases its magnetism for investment flows, its continued lack of correlation to traditional asset classes becomes the ultimate analytical input.

The World Gold Council ran a number of interesting statistics and scenarios in a recent working paper[1] showing how gold has been a consistent risk diversifier in addition to its traditional role as a store of wealth.

Their analysis showed that a 3.3% to a 7.5% allocation to gold (depending on the composition of the portfolio and the investor currency of reference) can improve the risk adjusted profile of the allocation even when other alternative assets are included.

In one of the tables produced by the study, we can see two different portfolios, a standard one allocated 55% equities, 25% fixed income, 5% cash and 15% alternative investments, and a conservative version allocated 30% equities, 50% fixed income, 10% cash and 10% alternative assets. The portfolios were tested for the trading period from January 1987 to June 2011 utilizing US Dollar denominated assets. In all cases portfolios with gold included scored higher Information Ratios with an optimal allocation to gold between 3.3% and 4.4%.

In this new turbulent investing environment, it is my belief that the old approach of trading around the mean hoping that investment returns will conform to an unrealistic bell curve will continue to disappoint and a more aggressive approach toward hedging and/or exploiting tail risk will continue to be key for some time.

Got gold?

HYPOTHETICAL RISK DISCLOSURE: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN, IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

[1] World Gold Council, Gold: Alternative Investment, Foundation Asset, October 2011

Thursday, December 29, 2011

Excerpts From Cervino Capital Management 2012 Market Outlook

12/28/2011

The business of forecasting is often a foolish endeavor; financial author and “enfant terrible” Nassim Taleb called the process of financial divining being “fooled by randomness” in his book by the same title. And yet every year, most financial participants will spend thousands of words dispensing their prognostications about the following 12 months. Admittedly, I am afflicted by the same disease, although my discretionary approach to investing and trading allows me for a convenient degree of flexibility in changing my positions when it becomes apparent that the assumptions of the original prediction were unfortunately wrong.

This year the dynamic of forecasting seems even more foolish than ever; the European crisis remains largely unresolved and still centerpiece to every future macroeconomic development. The first quarter in 2012 will see $850 billions of debt to be rolled over and 1/3 of that amount just from Italy. Should the market continue to keep interest rates above 7% for Italian debt, the pressure on the ECB to intervene in dramatic fashion will probably prove unstoppable. Any large scale intervention by the ECB should calm markets and ignite a new leg up in gold. A refusal of the ECB to bend to market and political pressures might prove highly deflationary and possibly result in a reformation of the Euro currency.

The development of the Euro crisis influences all markets with the results of increasing correlations across the board. The Euro should remain weak but volatile as every time a positive piece of news is leaked by Brussels, Paris or Frankfurt, short covering rallies will continue to occur in swift manner. Equities all over the world will also remain hostage to Europe. European stocks seem cheaper than US equities but much closer to the epicenter of the crisis. US stocks are not tremendously expensive but, in a world of higher correlations, still exposed to a dire recession in Europe and a now manifest slow-down in emerging economies. The level of EPS for US stocks is also worrying as they seem to be at the top of a positive earning cycle. One of the faults of fundamental analysis is that things always look best at the top. However, all considered, US equities might be the default choice for 2012 as they are in a stronger position than European and Emerging Markets equities, more attractive than most fixed income instruments and probably less volatile than I expect commodities to be in the new year.

On the subject of commodities, I expect increased volatility as the result of a few factors: Europe, uncertain Middle East developments after the Arab Spring of 2011 and the MF Global fiasco. The alleged criminal actions that took place at MF Global leading to its demise and the fumbled handling of the situation by most parties involved, especially the CFTC and the CME, have resulted in a negative structural issue with the commodities market. The Chicago Mercantile Exchange, the largest commodity market in the world, has seen its trading volume cut by 10% since the MFG bankruptcy. Part of this decrease is due to some trading funds still frozen at MFG but also to hedgers and speculators looking for alternatives to the futures market. This is a very negative development as a healthy and efficient financial system needs a healthy, secure and transparent hedging market like futures.

I also expect Master Limited Partnerships (energy infrastructures) to continue to do well and outperform most sectors. My long term play on natural gas and water remains, in my view, a centerpiece of any long term portfolios.

In conclusion, I will be expecting high levels of volatility in the first quarter of 2012 as we work through the European crisis; I will be monitoring closely the political debate in Europe and the actions (not the words) of the ECB. Technically, I will also keep an eye to the correlations between the Euro banking sector and gold to spot potential turns in this saga. Should I see the ECB become more aggressive in its own quantitative easing program, I shall expect gold to once again outperform. On the equity side, I expect Master Limited Partnerships to remain a favorite buy on most dips.

One last element not to be forgotten is the US presidential election in November. While not as pivotal as other past elections, the rhetoric of the political debate might turn nasty and prove destabilizing. However, election years tend to be generally kind to the market as short term policies are hastily put in place to keep the incumbent president on the job.

One thing is for sure…we will not be bored!