FMO: Undervalued By Historical Trends, Midstream Valuations Should Pick Up In 2020

ETFS

In our next article focusing on MLP-related CEFs, we will present to our readers the Fiduciary/Claymore MLP Opportunity Fund (FMO) which was incepted in December 2004. It is one of the smaller closed-end funds which is primarily invested into MLP entities and has roughly $680 million in AUM. The fund has been distributing its shareholders a quarterly dividend payment of $0.3231 per share since Q2 2018. That makes up an attractive 16.68% market distribution rate as of February 5, 2019, which might look very attractive for investors looking for high-yield investments. In addition, this fund trades at a 7.3% discount to NAV, which should offer potential investors an adequate enough bargain for this type of investment. In terms of the key bullish catalysts, we find them as the following: (1) the MLP asset class is undervalued compared to other asset classes and its historical valuation, (2) distribution growth should pick up as midstream companies are well-positioned to capitalize on underlying positive industry-related market dynamics.

About the Fund

This fund is primarily focused on MLP entities, including public, non-public and fixed-income securities. In addition, the fund can invest in other large-cap corporations as well, which are primarily involved in the energy, natural resources or real estate industries. Under normal market conditions, the fund invests at least 80% of its managed assets available in MLP entities. Further, at least 65% of its managed assets should go into equity securities of MLP entities, while up to 25% of its managed assets should go into debt securities (both investment grade and junk) of MLP entities. In addition, the fund currently uses a 1940 Act leverage ratio of 37.55%, which is in line with its direct peers.

The fund is structured as a C-corp, therefore its distributions to common shareholders are constituted as the return of capital, which should act as a tax-advantaged source of income for existing shareholders. The listed expense ratio on the fund website is 6.33%, compared to 4.4% (based on data for FY 18) of its biggest direct peer Kayne Anderson MLP/Midstream Investment Company (KYN). Therefore, investors should decide whether they are willing to pay such a hefty fee for a current double-digit distribution yield, which comes with the capital deprecation risk over the long run as well. Nevertheless, the most affordable option for retail investors remains the ALPS Alerian MLP ETF (AMLP), which charges an annual expense fee of approximately 0.85%.

(Source: Fund Website)

The majority of the companies are listed in the midstream oil & natural gas sector, while gathering + processing and diversified infrastructure sectors represent a significant portion as well. In our view, midstream oil & natural gas sectors are suitable for longer-term conservative investors, given that the primary driver is the volume of energy-related products coming through pipelines. For instance, the second-largest holding in the fund – Magellan Midstream Partners LP (MMP) – derives around 75% of its total revenue from transportation and terminals-related fees.

(Source: Fund Website)

This fund has a similar portfolio construction like its direct MLP-related CEF peers, as the top 10 holdings have a weight of approximately 5-10%. If we sum them up, then the aggregate weight of the top 10 holdings is approximately 69%, which is quite a high exposure for our risk tolerance. In general, we prefer a more diversified construction of portfolio with less than 5% per individual holding.

In our view, FMO is slightly overexposed to the largest holdings like Energy Transfers (ET) or Magellan Midstream Partners in the midstream sector with a weight of approximately 11.5% and 8.3%, respectively. Nevertheless, our fellow SA contributors are highly optimistic about the future stock performance of both companies, as they have assigned at least a Bullish rating. In fact, sell-side analysts anticipate that ET and MMP can reach an upside potential of approximately 56% and 13%, respectively, over the next 12 months.

List of other MLP-related CEFs

(Source: Fund List)

According to the figure above, our readers can find the biggest 10 MLP-related CEFs which have AUM in the range of $600 million to $3 billion. In general, they offer a dividend yield of approximately 10-15%, while the largest Alerian MLP-related ETF offers a distribution yield of 9.67%. As we have previously stated in our article analyzing Goldman Sachs MLP Energy Renaissance Fund (GER), the current market price distribution rates of MLP-related CEFs are significantly higher compared to the yields of other asset classes, including government securities, high-yield corporate bonds and return on REITs. Consequently, investors should be aware of the higher risk they are taking by investing in MLP-related CEFs. When it comes down to the highest distribution rates, Tortoise-labeled funds top the list, as they offer a slightly higher dividend yield of more than 15%. FMO is basically managed by the Tortoise Investment Management company and has a similar portfolio construction as other Tortoise MLP-related CEFs on the list. It appears to us that the only difference is that FMO is marketed and wrapped into the investment product by Guggenheim Investments to reach their existing or prospective clients.

(Source: YCharts)

Furthermore, some of the previously mentioned MLP-related CEFs have been trading at a discount to NAV in the range of 5-9% over the last year. We believe that is a result of undergoing secular trends in the energy-related industries as well as the bearish sentiment of momentum-driven investors.

Market Dynamics

Secular trends are positive for this MLP, and our readers can find more information about the future U.S. oil and natural gas production outlook in our previous article on GER. Nevertheless, Tortoise Investment Management sees a positive outlook for several key underlying variables. The company is bullish about the long-term prospects of the industry, as it remains positive about the health of the overall midstream industry. The key bullish catalysts are attractive valuations and resumption of distribution growth.

(Source: Investment Commentary)

According to the figure above, MLPs appear undervalued since late 2016. They were also undervalued back in 2008-2009 during the financial crisis, as well as in late 2016, when the price of crude oil plummeted to record low levels of the mid-$20s.

(Source: Trading View)

In our view, the primary driver is the underlying price of crude oil, which was in decline during times of MLPs’ undervaluation, as that can be reflected in the figure above. One exception is the most recent uptrend in crude oil price between mid-2016 and 2018, which didn’t lead to higher valuations of MLPs. In our view, investors are concerned over the long-term demand of the oil industry given that renewable energy sources are expected to make for a higher proportion of energy consumption over the next couple of decades. Tortoise Investment Management stated the following during the most recent investment commentary:

“MLPs had weak performance during the fourth quarter but turned positive for the year on a strong December return of 8.53%. Pundits and market commentators pointed to fears of a global economic slowdown and expectations for weak global oil demand as the culprit for weak energy returns during the quarter. It is more likely to us that the recent weakness reflects the expectation that growing U.S. production will keep the market oversupplied.”

(Source: Investment Commentary)

In addition, we believe that momentum-driven investors have been quite bearish about the overall energy industry over the last year. Therefore, value investors might now find undervalued gems in the energy industry capitalize on this trend over the long run.

(Source: Investment Commentary)

In our view, energy infrastructure build-out might also be a negative thing for existing MLP entities in a certain region (e.g., the Permian basin), as competitors might enter the market. In addition, we anticipate that commodity prices will remain volatile throughout 2020, primarily driven by political uncertainty over U.S.-Iran relations or due to potential trade disputes with China or the EU. Interest rates should remain flat and steady in the near future, as the Fed members stated during the previous meeting that the current monetary policy is adequate to support U.S. economic growth of approximately 2% in 2020 without any kind of significant inflationary pressures.

Fund’s Performance

(Source: Morningstar)

FMO currently trades at a discount to NAV of 7.30%, which is quite a high discount compared to historical trends. According to the figure above, the discount to NAV value has been very volatile on an annual basis between 2015 and 2018. For example, in 2015, the top value was a premium of 7.9%, while the low discount was 12.6%, which makes for an annual deviation of 20.5%. Nevertheless, in 2019, a particular metric has become more stagnant given the better outlook for underlying secular trends and the overall business performance of the midstream energy businesses in the fund’s portfolio.

(Source: Morningstar)

Based on the figure above, this MLP has generated a total return of -18.26% over the last year, or approximately 34% lower than the general global markets ACWI benchmark. In addition, it has underperformed both corresponding benchmarks – global MSCI ACWI and Energy Limited Partnership – in the time period of the last 3 and 5 years as well. However, if we take into consideration a longer time span of 15 years, then the MLP has underperformed the global MSCI ACWI and Energy Limited Partnership benchmarks for roughly 500bps and 240bps, respectively. Based on our analysis of historical total returns, we can conclude that investors in this fund have a better chance to achieve similar gross returns typical for the other asset classes if they hold it for a longer period of more than 10 years at least.

(Source: YCharts)

A 16.68% total distribution yield might seem too good to be true for regular investors. However, this high-yield distribution rate has been overshadowed by the very weak stock price performance over the last couple of years. According to the figure above, the stock has been largely underperforming comparable Vanguard Real Estate (VRE) and Alerian MLP ETFs over the last 5 years. In addition, the stock price performance has been slightly weaker compared to the biggest Kayne Anderson MLP closed-end fund on the market (-68.8% vs. -62.32%). The latter offers a significantly lower total distribution yield of 8.95% (market price as of 1/31/2020).

(Source: Fidelity Screener)

When it comes to historical distributions, FMO has returned to its shareholders a quarterly distribution of $0.3231 per share over the last seven consecutive quarters. In fact, a median quarterly distribution is around $0.3620 since the fund’s inception back in early 2005.

(Source: Author’s own computation; Fund Website)

However, a quarterly distribution was cut by 25% from the previous peak value of $0.43080 at the end of Q1 2018. Given that the fund offers a market price distribution rate of roughly 16.68% as of 02/05/2020, we advise our readers to acknowledge the risk of another potential distribution rate cut of more than 25% in the near future. Nevertheless, a potential risk factor might be a spread of coronavirus throughout entire China, which could lead to supply chain-related disruptions of major international companies. Consequently, that would most likely have a negative impact on the overall Chinese oil & natural gas demand.

(Source: EIA)

(Source: EIA)

According to both figures above, the US has been increasing its energy-related exports to China over the last couple of years. Therefore, an uncontrolled spread of coronavirus in China or even globally could have a negative impact on the overall volume of oil and natural gas traveling through the North American pipelines. As a result, the operational performance of MLPs and other energy-related midstream companies might be adversely affected.

Conclusion

We advise our readers to put this MLP-related CEF on their watchlist, given that it trades at discount to NAV, offers a double-digit distribution yield and has underperformed the other asset classes over the last couple of years. Further, we anticipate that the market valuation of MLPs should return closer to fair value as a result of positive market dynamics. Another important driver is the present health of the overall industry, which is in general neglected by momentum-driven investors. In terms of the investment holding period, our fund’s performance analysis reflects that investors were able to achieve positive market returns if they have been with the fund for more than 10 years. In our view, a present high distribution rate of more than 16.50% might not be sustainable over the next decade, given that MLP-related business comes with significant risks as well. In terms of major risks, investors should be aware of the fact that the company had already cut its distribution payment in early 2018. Additionally, this fund is highly exposed to the U.S. oil and natural gas production. Therefore, in the case of major geopolitical or regulatory shocks as well as unexpected pipeline outages in the near future, distribution payments might be negatively impacted.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article does not constitute a bid or an invitation to bid for the purchase or sale of the financial instruments in question. Neither is it intended to provide any kind of personal investment advice, therefore readers should conduct their own due diligence. Investing in financial instruments may always be associated with risk. Please contact your personal financial or investment advisor for any additional questions or materials regarding this article. We shall not be liable for any type of damage or loss arising from the use of the information contained in this article.

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