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The 4 Keys To Building Wealth - Midstream MLPs As An Example

The four keys to building wealth are falling prices, owning cash generating assets, reinvesting the dividends, and having decades on your hands to keep doing so. This is the case for all manner of assets, and there is no particular magic with midstream Master Limited Partnerships ((NYSEARCA:MLPS)). I simply chose to write about MLPs because prices for these assets have come down and may have further to fall, which makes for a perfect case study.

For background, midstream MLPs are mostly pipelines that move oil or natural gas from one point in the production stream to the other. Companies build the pipeline infrastructure, lease it out to oil companies, collect lease payments, and distribute those payments to shareholders.

The leases to the oil companies sometimes have escalation clauses -- these provide that with time, the oil companys rent goes up by a small amount per year. MLP companies mostly try to grow their distributions to shareholders by finding new projects, building more pipelines, and thereby generating more revenues from which to make larger distributions. And the way they fund those new projects is to issue more stock, or to borrow.

These are not favorable market conditions for an MLP company to issue new stock or take on more debt. As a result, the prospects for future dividend growth are bleak. In fact, one of the top pipeline companies in the USA, Kinder Morgan (NYSE:KMI) recently pared back its estimates for future distribution growth, citing difficulties in funding new projects. Take them as an industry bellwether for arguments sake.

For many investors, MLPs are yield-oriented assets, and as such, MLPs compete with other yield oriented assets, like bonds. If interest rates on bonds are rising, that makes MLP investments less appealing... UNLESS the MLP distributions can grow at least as quickly as the rate at which interest rates are rising. But many investors think interest rates for bonds could rise over some period in the future. To make matters dramatically worse, many also believe that distributions from MLP investments might not only fail to grow as quickly as interest rates are rising, but MAY NOT GROW AT ALL! Or even worse, MLP distributions may even FALL from where they now are!

The impact of those two forces colliding against the stock price of an MLP is comparable to that a wild-eyed adult male chimpanzee with a wrecking hammer throwing a complete fit in a china shop. Prices for MLPs have crashed already, but this angry chimp could have staying power. Years of staying power. Some investors dont prefer the risk of armed, angry chimps smashing their portfolios like delicate china, and opted to sell their MLP shares in favor of less, shall we say, exciting, alternatives.

I have no idea whether interest rates will do one thing or another, or whether MLPs will raise or cut distributions now, or in the future. I dont think anyone does. And whats more, I dont need to and neither do you. Here is why.

Assume that you start out with $1000 today, and you buy shares of an MLP trading at $10 a share. Assume that every year for the next 40 years, that stock is going to crumble and to keep crumbling. Its going to drop 8% a year every single year for 40 years. And thats not all! The dividends will drop too. The dividend yield is currently 10% (close to the yield for the ETF AMLP), lets say, but dividends are going to fall by 4% a year, every year, for 40 years. In other words, the angry chimp is here, and he is here to stay. Your first impulse may be that is not the investment situation for me. But remember that what you see are actually the first two conditions for building wealth: you have a cash-generating asset (although the distributions will be steadily decreasing), and you have persistently falling stock prices.

All you need now are the two remaining ingredients -- time and a persistent reinvestment strategy that will continue long into the future. So, what you are going to do is to collect your ever-shrinking dividend, and reinvest the money into the ever-falling stock price. Heres the executive summary of the outcome of this investment program. In year one, you have a portfolio worth $1,000 and portfolio income of $100, and in year 40, you have a portfolio worth $903,323 and income of $310,480. It is not the outcome youd expect from an asset with a price that drops 8% a year every year for 40 years, with steadily declining dividends. Its far more natural to simply see the chimpanzee with the hammer and want to scream run!!!!!! Many investors have.

(click to enlarge)

But this spreadsheet explains why instead of running, you might consider taking a pause, and to even start buying all the bits and pieces of broken china dishes in the wake of the angry market chimp with the sledge hammer.

The most important factor in this exercise, though, is that the stock price declines at a greater rate than the dividends decline. That is a huge assumption, but one I making now because I am extrapolating on what has happened over the past year. People say it was a bad year for MLP investors. The Alerian MLP Index ETF (ticker AMLP) is down by 27% -- but the dividends went from 29 cents a share to 30 cents a share. In sum, the stock price fell far, far more than the distributions (which grew modestly). Far from being a terrible year for MLP investors, if you look at the investment world through the lense of this spreadsheet, youd be celebrating. The angry chimp with a sledge hammer is your friend.

Just a quick aside. Getting cozy with angry, china-smashing primates seems like a lot of work, and some of you may be asking, why bother? Why not invest in a stock index like the Samp;P500? Samp;P500 companies pay close to a 2% dividend currently, and have tended to raise dividends by 7% a year over the long term, and stock price growth over many many years might be close to 7% (who knows, but its not an unreasonable wild guess to make). Why not avoid the angry chimp altogether? The following spreadsheet explains why in no uncertain terms.

(click to enlarge)

In short, you do far, far better as an investor when you hear the sounds of destruction and mayhem, and come running towards it with your tongue lolling, like you just heard the dinner bell. If you can make up a good argument for why stock prices will fall further and for longer, that is PRECISELY the reason why you should be far more compelled to buy more, and to keep doing so for as long as you can. Just dont expect many other investors to do so -- this sort of investment behavior very much goes against human nature.