Enterprise Products Partners Is Just Getting Started (NYSE:EPD)

(Note: This article was in the newsletter on May 24, 2023.)

Enterprise Products Partners (NYSE:EPD) is just getting to the part where the midstream industry cyclically grows. Mr. Market, however, stares at the “green revolution” and thinks that the industry will be gone “tomorrow”. However, the suppliers of materials to the industry report that business is relatively booming. Many companies I follow report good growth prospects for the foreseeable future.

The midstream industry traditionally has pricing action that follows the very cyclical upstream industry. This happens even though the midstream business itself is known as the utility part of the oil and gas industry. Therefore, actual business conditions do not exactly mirror upstream business conditions (to say the least). So, there is money to be made by following the upstream stock price cycle as opposed to strictly following midstream business conditions.

Knowing where you are in the business cycle is something that complements the Seeking Alpha quant system very well. The quant system by its nature is a follower of trends. Therefore, with any industry that follows a cyclical pattern, it often pays to know when the quant system will switch on an industry from a current bearish-type position to a bullish one. Often times an individual investor that “knows his stuff” and how to do due diligence can improve upon an already notable quant system.

Contrarian investing has long been the one verifiable investing system that outperforms the market on a regular basis. David Dreman, in his latest book, “Contrarian Investment Strategies: The Psychological Edge” details some of the results. Economists have evidently moved from dismissing those results to attributing them to above average risk. But the fact is that the economics crowd is finally getting around to admitting that something does beat the market. Combining some contrarian ideas with the quant system on Seeking Alpha is likely to prove helpful to investors.

Economics has long had a structural weakness in that economists assume that “man is a rational human being”. But psychology has debunked that idea a long time ago. Economists have long had a reliable prediction goal that really has claimed that psychology assumptions make too hard for equations to make those predictions come true. That is a fair enough argument. But it also means that the economic analysis is not as well-grounded as some of the sciences. Investors need to realize that when reviewing research in the investment area and using it accordingly. Finance is considered a part of economic and therefore uses more than a few economic ideas.

First Quarter Results

Mr. Market has long demanded certainty. Therefore, the growth resulting from an unexpected acquisition is now slowing down and Mr. Market sees nothing to replace it in the future. A good management like Enterprise Products Partners will not “sit still” and do nothing about the future. But Mr. Market will not value a good management until the specific proposal is sitting right under the nose of Mr. Market.

So far, the market is looking at the acquisition benefits as a one-time event. Never mind that the company has long grown through a combination of acquisitions and organic growth throughout its history. Currently, the common units are priced as though there will never be an accretive acquisition again the future.

The Contrarian View

Furthermore, that one-time growth from the acquisition and from the idle capacity is decelerating as the capacity fills and the acquisition is fully integrated. Therefore, Mr. Market sees nothing but “steady as she goes” until of course a solid proposal changes that picture. Betting upon management that has outperformed in the past can often beat the results of a numerical system because that system only gives a “buy signal” based upon history. It is using a perfectly good system to your advantage. Basically, the investor establishes a contrarian position when “nothing is happening” knowing that management will make something happen.

But missing from this picture is the idea that the acquisition gave the company a material “foot in the door” to the Midland Basin where a lot of players I follow are buying because the acreage is relatively cheap for the profitability. Therefore, activity is climbing. Enterprise Products Partners now has a presence upon which management can profitably expand in one of the hotter operating areas of Texas.

Also note that the partnership recently expanded its Haynesville capacity and has some more small projects that will complete in this fiscal year. That will help offset the growth slowdown now occurring.

Risk Of Buying Bargains

Anytime you purchase a bargain, it can become a greater bargain before appreciating. Even investors like John Templeton figured about one-third of his ideas worked. So, you do need a comprehensive plan to get out when you or if you, determine the story is not working. Diversification is also essential. No plan is full-proof.

The other thing about bargains is they can persist long enough to try your patience. One of the sayings about the market “can be irrational longer than you can stay solvent” has more than a bit of truth to it and some hard lessons as well.

Conference Call Backup

One of the discussions that has happened nearly every conference call (whether direct or indirect) is the acknowledgement that sooner or later projects begin to happen due to demand. The market will “ho hum” this discussion until actual projects are approved and the construction begins.

But nearly every single upstream cycle hits a point where more capacity is needed. That capacity addition often lags the industry cycle. This often results in construction that is ongoing when the upstream business cycle begins a downturn. Now all of a sudden, that extra capacity looks like a liability even through the construction is protected by volume commitments of some form (including acreage commitments among other things). There is also the take-or-pay provisions that protect the downside of midstream earnings.

Currently, most managements are at the point where discussions are beginning on capacity additions. Now the upstream growth is unlikely to be the rapid pace of the boom times. But that growth, combined with “old age replacements and repairs” is likely to prove significant to companies in the right place. This is one of those companies.

Key Ideas

Mr. Market long held that new capacity as a liability in fiscal year 2020 not realizing that someone had to pay for it. This actually dampens the effects of volume reductions in a downturn for a lot of midstream companies. As usual, the midstream crowd got no credit for that dampening effect.

Mr. Market further adjusts by giving no credit for the volume increases inherent in a cyclical recovery.

The result of all of this is a record high yield percentage because the market “knows” this is an income vehicle with little to no growth ahead. However, all any investor needs to do is review the history of the company to “know” otherwise.

One of the most poorly valued assets (by Mr. Market) not on the balance sheet is darn good management. Because this is a qualitative evaluation, the quant system has no way of predicting the effects of good management. All the quant system can do is predict that the past will be the future. To economists (statisticians may disagree) this amounts to managing a random event for as long as you can.

The way to handle this strategy in the finance world (since finance is a subsidiary of economics) was my professor had us buy “Beat the Racetrack” by William T. Ziemba. This was a way handling what economists viewed as “casual” or “random” relationships for as long as the relationship held.

Basically, this is a way to win by finding casual relationships that “work” until they do not. As my professor noted, there are many books in related areas that do the same thing. There has long been “theories” out there upon how to handle relationships without good theoretical grounding for as long as they work while making a profit from them. Many sciences demand a good theoretical backup for a relationship or they deem in casual (it works until it does not) rather than causal (meaning it always works).

Note that economics has long identified that the market is efficient and therefore outperformance is not possible without extra risk. Some outside economics have an issue with that stance. My (old) Samuelson textbook also touches on this theme that David Dreman digs into quite a bit.

Management is one of those things that really cannot be quantified. But good management can be identified as one gains experience identifying good management. Investors can beat the market by identifying which companies will move from the “doghouse” to a more favored status by evaluating management in addition to all the things contrarian investment recommends. Even if they do not do this, contrarian strategies have long been shown to beat the market (especially for financially strong companies).

In any case, Enterprise Products Partners now offers a historically high yield that is nearly the average return many investors report long-term. Just about any growth is likely to move the investment into above-average (investment return) territory. Management has been repurchasing common units to assure a total investor return in excess of the company growth rate.

The partnership is a strong buy consideration based upon the current yield and that management that has proven to be “in the right place at the right time” in the past. It is probably a decent bet that even though “nothing is happening right now”, things will change in the future for the better. This good management is not going away any time soon.