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Don’t fall into the trap of thinking a downturn affects all companies in the sector the same way

For the speculative investors, there tends to go about finding their opportunities in 2 ways:

  1. the top down approach
  2. the bottom up approach

#1 tends to be the macro investors, who looked at interest rates, what the government does, which sector provides the best opportunities before making their investment decision.

#2 tends to be investors who just want to spot companies that may go against the industry trends, or that they are overall well run companies that are not too expensive to purchase.

I think most investors belong to the #1, even though they would like to believe that they are #2 as well.

The narrative is clear to me.

Most are just confused what they should do.

When you look at certain segments, you tend to see people avoiding the segment due to unfavorable scenario. While at times avoiding completely is correct, sometimes it is not.

The example of deteriorating fundamentals in the oil and gas industry is one example that most of the supply chain players get into problems. Even the well operating ones, eventually get their margin squeeze because their customers are not doing too well all together!

However, the tightening measures and the cautious economic outlook may not have beaten down all the property companies in the sector. Companies within the sector do serve different segments in the industry.

Real business man find ways to navigate challenging scenarios.

As an investor, your opportunity is when everyone adopts the “all stocks in the property sector is bad” mentality, beat down the share prices, while you find the potential ones that will operate well in such a prolong climate.

Of MLPs and REITs

Master limited partnerships are limited partnerships that are publicly traded in the USA. They need to be busienss that derive their cash flows from real estate, natural resources and commodities.

Most commonly they are associated with storage and transportation of natural resources and commodities particularly oil and natural gas pipelines.

They are cash flow generating, and are finance by equity (stock), preference shares, and debt, managed by a manager.

They are no different from real estate investment trusts (REITs) in that the model is the same. Industry, interest rates, economic outlook and manager capabilities are the main considerations.

When oil prices plunge, these MLPs get affected as well, due to the volume of business dealt.

The Alerian MLP index had a drawdown of 37% compared to 55% for the prices of oil.

Why is the MLP index suffering comparatively  less compared to the drawdown of one of their main consideration (industry)?

It turns out that within the Alerian MLP index, which is made up of real MLPs, there are the safe haven and the chaotic ones.

The safe-haven MLPs are priced like a Burgundy Grand Cru, with an accompanying weighted-average yield of just 6.3 percent. The distressed MLPs are priced like toxic subprime mortgages, with an eye-popping yield of 18.1 percent. (The safe-haven MLPs represent nearly 75 percent of the Index by weighting.)

But are safe-haven MLPs actually higher quality than their distressed counterparts, or are investors behaving irrationally?

There is a clear quality difference between the two groups of MLPs. The safe havens have lower leverage — a weighted-average debt-to-equity ratio of 1.2 versus a ratio of 1.4 for the distressed group. The safe havens also have a greater cushion for future distributions — a distribution coverage ratio of 1.5 versus 1.2 for the distressed group. The distributions of the safe havens grew by 44 percent last year while those of the distressed group grew by 21 percent.

Covet those Energy MLPs with Care

The lesson to be learn is that trust models whether in the USA, Singapore or another country, at a high concept level,  are largely similar, just that their parameters such as economic metrics and industry metrics differs.

There are the ones that operate better and then there are the ones who are wannabes who have no idea what they are doing. The latter tend to attract investors, by pulling the things that matter the most to them (perhaps dividend yield?).

The outlook might be challenging but the good operators would prove to be attractive at beaten down prices. while investing in the beaten down wannabes will be more hurt then joy.

It is also important to identify which of these metrics matter more. Would interest rates be such a big determinant or would the managerial skills and economic outlook far outweigh them?

Learning to buy based on a safer return, after considering all the metrics that matter, is better than looking at only one of the metric (interest rate)

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Sunday 6th of March 2016

don't fall into the trap of thinking you are good enough to pick the good ones that will rise during the downturn.

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