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There is one and only one S&P 500 sector that is up massively this year: energy.
You’d be forgiven if you missed the ideal moment to invest. But there’s an often-overlooked part of the energy sector that is essential to our way of life and still exceedingly cheap.
I’m talking about midstream oil and gas.
Midstream companies operate pipelines, tanker ships, and storage facilities. They are tasked with getting hydrocarbons from the production sites to the refineries.
The assets these midstream companies own are critical infrastructure. If midstream pipelines cease to operate, our day-to-day lives would drastically change.
There is a lot to like about these companies besides the essential nature of their businesses. They reward shareholders – dividend yields of 6% or more are common. They gush cash flow. And they’re historically cheap.
What’s more, these are attractive, resilient businesses. Operators typically enter into long-term contracts and make money from fees and on the volume passing through their pipelines. That makes them largely insulated from the short-term volatility of commodity prices.
Once a pipeline is built, it tends to have zero risk of new competition. For one thing, getting government approval for a new pipeline isn’t a simple process. But even if it was – the idea of building right next to an existing pipeline isn’t likely to be the best use of capital. This provides a competitive moat for midstream incumbents.
This is not a perfect investment. One downside that comes with investing in many midstream stocks is the dreaded schedule K-1. This is a federal tax document that reports the earnings, losses and dividends of certain businesses like limited partnerships. Owning securities that issue K-1s can make your tax preparation a lot more complicated.
But don’t be discouraged – there is a way around the K-1! Closed-end funds are a type of mutual fund that issues a fixed number of shares and trades on the open market. This is different than an open-end fund, which accepts new investment capital and is constantly issuing and buying back shares at a price based on the net asset value (NAV) of the portfolio’s investments.
There are over a dozen closed-end funds that specialize in midstream energy companies. Do your own due diligence, but of the ones I have looked at closely, none issue K-1s!
It gets better…
Since closed-end funds trade on an open exchange, their price typically deviates from NAV of the funds’ holdings. Sometimes a fund trades for a higher price than NAV (at a premium), and sometimes it trades lower (at a discount). When a fund is trading at a discount, you are purchasing the underlying assets on sale.
Midstream Funds Are Trading at Steep Discounts
Source: FactSet. Data as of 9/9/22.
The removal of the K-1 headaches might cause these midstream closed-end funds to trade at a premium. And in the past, that was correct. But today, I am seeing some truly extraordinary discounts in this investment space. Discounts in the teens are typical, and some funds have traded at more than a 20% discount to their NAV!
These are historically wide discounts. This is the margin of safety we want as investors.
These closed-end funds will see their NAV gap close. In the meantime, they offer exposure to a group of desirable midstream businesses at a tremendous discount.
Michael Joseph, CFA is a vice president and deputy chief investment officer at Stansberry Asset Management. He is a member of the CFA Institute’s Practice Analysis Working Body and sits on the board of the i.d.e.a. Museum Foundation and the advisory board of the Arizona Council on Economic Education. He can be contacted at [email protected].
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
