Even dividend stock picks can get too pricey: I'm selling Magellan Midstream Partners on valuation

06/07/2013 6:41 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

This is a tough one and I’d bet that many of you would disagree no matter what I decided.

The name in question is Magellan Midstream Partners (MMP), a member of my Dividend Income portfolio http://jubakpicks.com/

This master limited partnership has been a very, very good addition to the portfolio. At the time of the initial buy, these units paid a 7.3% distribution. Since I added the units to the portfolio on December 6, 2005, they’ve gained 60.3% (to the close on June 7, 2013.)

And that’s the problem.

The partnership has increased distributions every year. From $1.45 in 2010 to $1.56 in 2011 to $1.78 in 2012, but the increases in distributions haven’t kept up with the increase—27.4% in 2011 and 30.6% in 2012, for example, in the price of the units.

Consequently, the yield on this holding has come down every year—from 6.55% in 2009 to 5.15% in 2010 to 4.52% in 2011 to 4.13% in 2012 to 3.9% right now.

Why is that an issue? Because that falling yield is a sign that dividend stocks have gotten too popular. Especially recently.

Investors looking to stay in the markets but worried that the rally wasn’t sustainable have been flocking to dividend-paying stocks. To give you one indication of that the Vanguard Dividend Appreciation ETF (VIG) has attracted $2.2 billion so far in 2013. That’s almost equal to the $2.21 billion the ETF attracted in all of 2013.

And that has made dividend-paying ETFs, partnerships, and stocks more vulnerable than you might expect in the recent downturn. Magellan Midstream was down 4.14% from its May 22 high through the close on June 6. Vanguard Dividend was down 3.45% from its May 21 high. That’s surprisingly—to me anyway because I would have expected the investments with the higher dividends to have held up better —worse than the 2.79% decline in the Standard & Poor’s 500 stock index from May 21.

So a steadily declining yield—because of a very much appreciated increase in unit price—and more downside volatility than I would have expected.

The question is what do you do about that?

3.9% isn’t a terrible yield in the current market—although it is less attractive if interest rates are on the rise as they have been recently and look to be longer term as the market frets about the Federal Reserve tapering off its purchases of Treasuries and mortgage-backed assets.

The business model at Magellan Midstream Partners is a relatively low-risk one, too. More than 50% of the company’s revenue is tied to fee-based contracts that are linked to inflation. Looking at the appropriate inflation index, the Producer Price Index, Credit Suisse calculates that Magellan will see a 4.6% increase in these fees in July. If you add in new projects such as the reversal of flow direction and expansion in the Longhorn pipeline and the acquisition of refined products pipelines from Plains All American (PAA), then I think you’re looking at an annual average growth in distributions of 10% or so over the next three years.

A 10% annual growth rate for payouts certainly isn’t anything to sneeze at in this market or any other.

So do you hold on because this a low-risk, well-managed pipeline master limited partnership with a projected 10% annual increase in distributions or do you sell because you think the recent popularity of dividend paying stocks has pushed Magellan’s price to overvalued territory?

I think that answer depends on whether you think 1) you can find a better yielding dividend play and 2) how quickly you think interest rates might rise this year.

Me? I’m inclined to sell and see what research and time bring my way in terms of a higher yield. (I’m also trying to control a tendency for this portfolio to hold too much in the energy sector and in master limited partnerships.)

But I certainly respect the alternative decision.

With this post I’m selling Magellan Midstream Partners out of my Dividend Income portfolio http://jubakpicks.com/

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares in Magellan Midstream Partners as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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