COVID-19's Final Act And Epilogue
by Tyson Halsey, CFASummary
- COVID-19 is winding down.
- MLPs and MLP closed end funds are a bargain.
- The stock market has upside but there are many risks.
The COVID-19 tragedy is entering its final stages. The rate of coronavirus spread and death have slowed. Social distancing policies and stay-at-home orders have mitigated worst case death projections like the estimate of 2,200,000 and 510,000 deaths in the United States and United Kingdom, respectively, by Imperial College of London’s renowned Neil Ferguson. Death projections are one tenth Ferguson’s early estimates. The cost of the mitigation has unfortunately devastated the US economy and the path to normalcy is unclear and partisan.
COVID-19's Peak and Promise:
Below is a chart of US coronavirus deaths. The deceleration and decline in cases is clear.
Source: Fox News
Progress in vaccine development is advancing at a rapid pace providing hope of total coronavirus elimination. Top major pharmaceutical companies AstraZeneca, Moderna, Johnson & Johnson and Sanofi have announced promising vaccine candidates whose availability could be as early as October and within the next 12 months. Therapeutics treatments are also proceeding rapidly like Remdesivir, Hydroxy Chloroquine and convalescent plasma. These medical advances will accelerate the global recovery from the Coronavirus as countries return to post virus normalcy like that being enjoyed by China and South Korea.
We remain constructive on an economic recovery based on progress made in containment, tracking, and medical advances. To quote five facts highlighted by Dr. Scott Atlas of Stanford Hospital and the Heritage Institute in his article “The Data is in--stop the panic and end the total isolation”.
The Economic Impact:
The Lockdown Recession of 2020 has had a devastating economic impact on the United States. The chart below shows the 12% peak to trough GDP decline—a decline that is three times worse than any recession since World War II.
Source: Bloomberg News
The staggering 38.6 million filings for unemployment since March is leaving a horrible impact on the American family who only 69%, according Cameron Huddleson, have $1000 in savings. The chart below shows the unparalleled spike in unemployment which now has declined to levels ten times the filing rates before the Coronavirus lockdown.
Source: TradingEconomics.com
Sentiment is Improving:
The chart below of consumer sentiment shows an encouraging bounce despite the horrific jobs data. This may be due to the belief that nine out of ten workers expect to return to work after being furloughed, according to USA Today.
Source: Bloomberg TV
The Markets and Where to Invest:
The two charts below are of the S&P 500 over the last five years (left) and one year (right). The charts suggest that the equity markets have stabilized following the Double Black Swans of the Coronavirus and of the OPEC+ oil crash. The equity markets’ prospects now hinge on varied uncertain economic factors including the economic recovery, the US-China economic relationship, geopolitical risks, global recovery from the Coronavirus and this November’s US Presidential election.
Source: Interactive Brokers Trader Workstation
Fed Model Buy Signal has Weakened:
Our Fed Model Risk Premium Model gave us a compelling buy signal in late March with a risk premium of 6.29. Today, the Risk Premium has declined to 3.94% as shown on the chart series below. This indicates that the stock market is no longer a compelling bargain since the S&P 500 has rallied 32% in the last nine weeks from 2229 to 2955.
MLPs and MLP Closed End Funds are compelling:
MLPs are logical investments. MLPs are inexpensive and still recovering from the COVID-19 equity market collapse and the March 9th 24% crash in WTI and Brent oil prices. The MLP sector experienced extreme undervaluations from oversold conditions from a financial perfect storm of forced liquidations by leveraged closed end MLP funds, collapsing oil prices and crashing equity market prices.
Midstream energy MLPs are fee based businesses, whose operating earnings are tied to volumes not the commodity price. The March perfect storm of panicked and forced selling created a rare opportunity to buy solid businesses at extreme undervaluations. MLP closed end funds, in particular, traded to 30-50% discounts to the liquidation value or NAV of portfolios of defensive high yielding Master Limited Partnerships.
Source: Macrotrends.com and Alerian.com
On March 18th, closed end MLP funds Kayne Anderson MLP/Investment Company (KYN) and Kayne Anderson Midstream/Energy Fund (KMF) closed at 37.5% and 47.6% discounts to NAV. As of Friday, May 22th, their discounts to NAV were:
- KYN closed at $5.76/share with a NAV of $6.90/share—a discount to NAV of 16.5%
- KMF closed at $4.88/share with a NAV of $6.02/share—a discount to NAV of 18.9%.
Both MLP funds and MLPs will benefit from their exceptionally high yields and improving US economy. Yields on MLPs dwarf other yield investments and trade at an 11.46% premium to 10-year US Treasury notes. Historically, this MLP to US Treasury spread has averaged below 5%. For this spread to narrow to its historic average, MLPs will need to double in price from current levels. To be conservative, we estimate that there is 50% upside to MLPs from today’s prices.
The chart below on the left shows the spread of MLPs over US Treasuries. The chart on the right shows how the Alerian Index AMZ yield 12.14% is far higher than alternative income investments REITs 4.48%, Utilities 3.8%, S&P 500 2.08% and 10-year US Treasuries 0.64%.
Natural Gas MLPs:
We are optimistic on the future for natural gas due to its environmentally friendly profile. Additionally, recent drilling rig shut-ins have curtailed the availability of natural gas. This presents a scenario for higher natural gas prices which bolsters our optimism on natural gas MLPs.
Antero Resources (AR) and Antero Midstream (AM) are two MLPs with significant upside if natural gas prices remain constructive. Antero Resources and Antero Midstream combined are the largest exporters and second largest natural gas producers in the US. Both are highly leveraged, but due to improving natural gas prices are experiencing a significantly improved operating outlook. In the first quarter, Antero Resources repurchased 27 million of their own shares at $1.57 and spent $120 million repurchasing their own debt at a discount to par value. Rarely do we see such stock and bond repurchases by corporations, but in such a stressful market environment, the message is unequivocal.
Antero Midstream has a $0.3075 quarterly dividend, which implies $1.23 in annual distributions and a 28.6% yield on its $4.3/share closing price. AM has 1.1 distribution coverage and lower leverage than its comparables.
Antero Resources has a hidden asset. AR will be selling a portion of its net well interest ((NWI)). AR has 84% NWI. Range Resources (RRC) has 79.4% NWI. The Permian Basin NWI average is 75%. According to analyst Travis Koldus, CFA, AR can sell 1% of their net well interest NWI for $300-450mm and that they will close on this in coming months. This Net Well Interest sale will alleviate a bankruptcy risk that the market has feared. This transaction will change the risk perception associated with AM’s 28% yield and drive it toward 15%. We believe that AM’s yield will drop to 10% resulting in a triple in AM’s stock. AR could reach $20/share from $3.22/share. The appeal of a triple in AM with a 28% dividend or six fold move in AR is a compelling reallocation.
With the COVID-19 and the oil market crash, the Alerian MLP index dropped 67% and levered KYN declined from $12/ to $1/share in a massive margin call selloff experienced by many closed end MLP funds and leveraged players. We have been adding and recommending KYN position at large discounts to NAV for the last nine weeks and since the marketbottom. KYN is still attractive and can trade to $9/share and possibly $12/share in one year. However, reallocating some capital from KYN or KMF could make sense.
Below are charts of Antero Resources Corporation (AR), Antero Midstream Corporation (AM), Kayne Anderson MLP/Investment Company (KYN) and Kayne Anderson Midstream/Energy Fund (KMF).
The economic shock and market decline experienced in recent months has been historic. This has left compelling investment opportunities for those willing to do the research.
Disclosure: I am/we are long AR, AM, KYN AND KMF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.