The market is doing very well Monday and Tuesday of this week but if I look back over the last month or two sector-rotation is telling a slightly different story. Industry groups tend to rotate in and out of favor with investors as the business cycle changes. In the early stages of a rally, technology, finance, and basic materials stocks tend to do better than others. Towards the end of the cycle – as a correction or channel starts to look more likely – defensive sectors like healthcare and consumer staples start to outperform the riskier stock sectors that were doing better in the early stages of the rally. Along with defensive sectors, traders get much more interested in income bearing stocks when growth starts to fade.
High dividend paying sectors like utilities tend to do well when stocks are starting to flatten out partially because they have low volatility in their business models and because they pay income. Unfortunately, utilities might be the only place some traders look for new entries when stocks get choppy. However, there is another class of stock that can be superior in these market conditions called Master Limited Partnerships (MLP). These are similar in many respects to unit investment trusts like REITs. However, instead of investing in real estate most MLPs are involved in the transportation and processing of energy commodities like oil, natural gas and propane.
MLPs must pay 90% or more of their net income to their shareholders (AKA “unit holders”). That means that analysis of these instruments will be a little different than it would be with a regular company. Everything from depreciation, to EPS and the balance sheet has to be evaluated based on a different set of criteria than you might use for Apple (AAPL) or Wal-Mart (WMT).
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I like Amerigas Partners LP (APU) in this category, although there are several that are similarly attractive for investors worried about diversification opportunities in this market. My idea is to buy Amerigas Partners LP (APU) on a break above resistance at $45 per share. Some traders may also wish to sell covered calls against the position in between dividend payments to further smooth returns. The stock has a dividend yield of nearly 8% and has paid that reliably for several years, which is the kind of consistency that I look for. Investors may initially have some concerns about MLPs right now because they have been lagging the market since early 2011. However, what they aren’t accounting for is that this is normal.
MLPs and other defensive or income generating assets tend to underperform when risk assets are doing well and then rotate into favor when growth starts to ebb. Despite Tuesday’s new highs on the Dow and S&P 500 I still feel strongly that growth expectations in the near term are low and investors will be turning their attention to income and safety. APU is nicely positioned to benefit from that shift and has already been showing a significant level of relative strength compared to its peers and the broad market index. The chart below graphs the relative performance of APU compared to the S&P 500 (red line) over the last several weeks.
Amerigas Partners (APU) vs. S&P 500 Index (SPX): Chart courtesy MetaStock Professional
As compelling as this is, its an incomplete picture and one of the most significant mistakes that investors make when trying to understand the performance potential of an income producer like APU versus the broad market indexes. The issue is that companies like this don’t retain earnings like a regular company does; they return it to shareholders. Those dividends have to be included in the calculation in order to make a fair comparison. In the chart below you can see the total return (including dividends) of APU and the S&P 500’s index tracking ETF (SPY) over the last few years.
Amerigas Partners LP (APU) total return vs. S&P 500 ETF (SPY) total Return: Chart Courtesy of YCharts
The chart above assumes a long-term holding period for those dividends paid by APU to smooth returns and amplify performance, which is an important point to consider. It seems reasonable to assume that APU will outperform the S&P 500 in the short term if the market does flatten or decline a little as a whole. However, investors usually consider timing an entry into high-income producers and defensive stocks when they are rebalancing and considering a longer term position.
APU provides portable propane gas and equipment. That includes everything from the propane tanks you can exchange at the gas station or supermarket to propane heated appliances and homes. Like many companies, APU has seen annual declines in their business over the last several years due to the recession and the slow recovery in housing. However, housing trends fundamentally changed in APU’s favor in 2012 with the first uptick in propane heated homes since 2005. Additionally, APU acquired the propane operations of Energy Transfer Partners (ETP) in 2012, which should start to have an impact on operations and profits in 2013 by lowering costs and increasing the potential customer base. Those benefits have not been fully priced into the stock due to competition from risk assets in higher growth sectors.
Currently, APU is breaking out and looks likely to meet their 2013 goals of increasing EBITDA by over 50% in 2013. The company has added leverage as part of their 2011-2012 acquisition but it should put them in a much stronger position to grow with the housing market in 2013-2014. This should drive the dividend in absolute terms and the stock’s price over the next 18-24 months. I like an entry on a breakout above $45 per share. That is still technically within the current long-term consolidation but is above near-term resistance and should confirm momentum.
Trading options on MLPs like this is tricky. For example, puts will be overpriced because the put holder receives the theoretical advantage of the drop in price when the stock pays a dividend. It also sometimes looks like calls are underpriced for the same reason. This phenomenon catches even very experienced option traders off-guard sometimes. I don’t recommend an outright call position as an alternative to a long position in APU. However selling calls against the long position in between dividend ex-dates could be a very effective way to reduce volatility.
Although APU isn’t really considered a “defensive” stock or a utility it is often included in both categories because of the stability of its business model and the high growth. I like an entry here as a way to diversify ahead of potential volatility. However, remember that unlike many of our past trades the timing is all about getting into the trade while it is undervalued for the long-term rather than a short term hold.
Note about MLP dividends:
Although the dividend is attractive – MLP dividends are ‘unqualified’ which means they are not generally taxed at a capital gains rate. Talk to a qualified tax advisor if you have questions about holding an MLP in a tax sheltered account and its impact on your overall tax situation.
- The Ticker: APU
- The Trade: Buy at $45
- Trade Opened: March 6, 2013
Chart courtesy Finviz. Click to open in larger window.
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