If you follow the MLP space at all, you are aware that the largest MLPs dominate the market cap weighted indexes that track the space. The largest 2 MLPs, Enterprise Products Partners (EPD) and Kinder Morgan Energy Partners (KMP), account for 25.3% of the Alerian MLP Index, and the top 10 most weighted (out of 50 names) account for 59.3% of the index. But those numbers are down slightly from 5 years ago when the top 2 and top 10 accounted for 25.7% and 64.8%, respectively.
In MLP land, it is not a case of the rich getting richer, but a case of the whole sector getting richer. The top 5 largest MLPs by index weight currently carry a market capitalization that is roughly 19x that of the average of the bottom 5 weighted MLPs in the Alerian MLP Index. As shown in the chart below, that 19x multiple is slightly more than it was 5 and 10 years ago, but not by much. What the numbers below show is that the sector is growing in company size from top to bottom, a reflection of the asset class maturing with more funds flowing into and also a reflection of the MLPs collectively gaining scale.
The chart above also is interesting in what it leaves out: the middle 40 MLPs. If the average market cap growth of the index as a whole over the last 5 year was 135.8%, and the top 5 and bottom 5 weighted names grew 120.6% and 109.1%, respectively, then that means the middle 40 MLPs grew the most. The average market cap of the middle 40 weighted MLPs in fact grew 138.3%. The middle 40 MLPs now represent 58.6% of the total weight, compared with 54.7% previously.
This sector wide growth is the sign of a healthy industry that has consistently gained assets over the last decade. The growing size of individual MLPs will help attract more institutional capital to the sector and will be a technical positive tailwind for the sector going forward. It represents a virtuous circle of market cap growth leading to more interest and higher fund flows into the sector. More capital for MLPs means more growth projects and acquisitions can be executed leading to more distribution growth. This self-reinforcing cycle was broken temporarily in late 2008 and early 2009 due to a lack of available capital, but that brief period has been a rare exception rather than the rule for MLPs since 2001.
Relative Size, Relative Returns
There are many reasons to think owning smaller MLPs is a good idea. The law of large numbers says it’s easier to grow a smaller asset base than a larger one. It’s also generally a good thing to be able to identify companies before those companies gain broad institutional interest or awareness. As an MLP grows, it gains research coverage and gains larger institutional interest, and that new investor awareness helps smaller MLPs outperform those that are “old news” to MLP investors.
Also, typically there is a liquidity premium placed on the largest MLPs (i.e. bigger MLPs are consistently valued higher). Higher entry points, all else being equal, will lead to lower returns. All of this favors small MLPs. The big advantage of large MLPs is their ability to raise cheap capital because they carry premium valuations and often carry investment grade debt ratings.
Year to date, the 25 highest weighted MLPs in the Alerian MLP index have total returns on average of 3.4%, which is significantly less than the other, smaller 25 MLPs in the index that have averaged total returns of 4.8% so far this year. By comparison, last year those same 25 biggest MLPs (+13.4%) well outperformed the smaller ones (+1.8%).
The chart below highlights the extremes, the 5 largest and 5 smallest weighted MLPs at a given time. Those 5 change in each time period in the chart, see the end of this article for details on the constituents of each grouping.
Results have been mixed at the extremes, since 2001, the smallest 5 outperformed and since 2006 the largest 5 outperformed. The most consistent bet has been the middle 40 MLPs, as evidenced by the extremes underperforming the index the past 10 years.
The smallest cap MLPs tend to have the highest failure and distribution cut rates in the sector, which reduced their returns the last 5 years. It can be very rewarding if you can pick the right small caps that will develop and mature into safe secure MLPs. But what these numbers tell us that investing in the smallest cap MLPs is perhaps not worth that risk, while the top 5 largest MLPs struggle to live up to their premium valuations. Like with Goldilocks and the 3 bears, somewhere in the middle is just right.
Notes on Constituents
2001: The smallest 5 MLPs by weighting were: GEL, SGU, APL, Cornerstone Propane Partners, and NRGY. Given that Cornerstone went away soon after, I have including the next largest MLP that is trading today: TCP. The largest 5 MLPs by weighting (in order) were: KMP, EPD, OKS, EEP, and TPP. Because TPP was purchased by EPD several years ago, I have added the next largest one, PAA.
2006: The smallest 5 MLPs in the index were: NRP, GLP, TLP, U.S. Shipping, and Inergy Holdings. U.S. Shipping went out of business, and Inergy Holdings was bought out by NRGY. The next largest MLPs in the index (that are still around) were SGU and AHGP. The 5 MLPs with the highest weightings were EPD, KMP, PAA, ETP and TPP. Because TPP was purchased, I have included the next highest weighted, OKS.
2011 (Current): In the current weightings of the index (as of December 2011), the smallest 5 MLPs are PSE, QRE, CMLP, MMLP, and EXLP. The 5 MLPs with the highest index weighting are currently EPD, KMP, PAA, ETP, and MMP.
It should be noted that the Alerian MLP Index weightings don’t necessarily match up with the actual market capitalizations of the MLPs in the index. A clear example is Williams Partners, with an equity market cap that ranks 3rd overall in the sector at more than $16 billion (behind only EPD and KMP), carries the 13th highest weighting within the Alerian Index. On the other end of the spectrum, the smallest market cap MLP included in the index is Martin Midstream Partners (MMLP) at just $668 million, has the fourth lowest weighting.
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