NEW YORK (TheStreet) -- The market volatility that started this year has led investors to seek out safe havens and has led to a retreat in interest rates. The 10-year Treasury is 40 basis points off its high of 3% reached in December.
The drop in rates has resulted in a strong bid for higher yielding equity investments such as real estate investment trusts, utilities and master limited partnerships, all of which gained in January while the S&P 500 dropped 3.5%.
If you believe this recent pullback in rates is a short-term blip, income-oriented equity investors need to be particularly selective in their stock picking and focus on distribution growth.
Distribution growth offers three primary benefits: (1) preserves purchasing power which functions as a hedge against inflation, (2) offers protection against rising rates and (3) drives future price appreciation.
Many investors are aware of the high current yield offered by master limited partnerships, which generally fall into the 5% to 8% area. However, fewer pay appropriate attention to future distribution growth and what it can mean to their investments over time.
Let us look at a simple example to illustrate the power of distribution growth:
Vanguard Natural Resources LP (VNR) is a successful exploration and production (upstream) MLP that offers a current annualized yield of nearly 8.5%, while Atlas Energy LP (ATLS) is a general partner MLP with an indicated yield of 4.0%.
Given the need for current income, an income investor might choose to invest in VNR. In this scenario, the income investor has neglected forward growth rates and its effect on price appreciation
VNR has grown its payout at an annual rate of about 4% over the last three years and is projected to grow at a rate closer to 2% going forward. ATLS, meanwhile, has grown its distribution at an exponential rate in recent years and analysts estimate 20% distribution growth for the next three years.
All else being equal, the income stream of a $100 investment in VNR (at 4% growth per year) vs. ATLS (at 20% growth per year) is equal after five years.
However, price appreciation is much different. If the growth expectations for ATLS remain the same by year five (indicating it deserves to be priced at a 4% yield), an increase of 149% in income from $4 to $10 implies price appreciation of 149%. VNR's price appreciation would be roughly 22% under the same assumptions.
As with all stocks, expectations for future growth, whether it be earnings or distributions, will drive stock prices over time.
Where to Find MLP Distribution Growth
Given what we have outlined above, one method to identify those MLPs that provide the most total return potential is to calculate the implied forward return by adding current yield and distribution growth. While simplistic in its approach, this serves as a good barometer for potential total returns, all else being equal.
This simple analysis reveals something quite interesting. The sector with the lowest current yield, General Partners, provides the highest projected total return at 23.6%. The total return is almost entirely the result of distribution growth.
Investors looking to capitalize on this opportunity can choose to invest in individual MLPs or use broad rules-based exchange-traded funds that focus on distribution growth. For example, the Yorkville High Income Infrastructure ETF (YMLI) has a current yield of 6.3% and average distribution growth of 6.7 % (fourth quarter year-over-year) by having more exposure to general partner and gathering and processing MLPs than its peers.
On the underlying partnership level, MLPs with cash flows that are both stable and growing provide compelling total return potential.
An example is Oneok (OKE), a C-corp MLP general partner with a 2.7% current yield. OKE just spun off its utility business (One Gas (OGS)) and is in the process of exiting its unprofitable energy services segment. For 2014, OKE expects to pay a dividend of $2.13, which represents an increase of 40% versus 2013. The company expects to grow its dividend at a rate of 10% annually for 2015-2016, leaving OKE relatively undervalued in comparison to its peers.
As general partner to these three MLPs, ETE benefits exponentially from distribution growth at the underlying MLPs. In 2013, ETE announced its intentions to form a fourth MLP subsidiary to hold its Trunkline LNG export terminal project. ETE also resumed growing its distribution and announced a $1B share repurchase during the year contributing to a total return of +88% in 2013. ETE could have annual distribution growth in the mid teens over the next five years providing an attractive forward return outlook.
At the time of publication the author had positions in the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.