Master Limited Partnerships (MLPs) are one of the more tax efficient income generating investments around, given that investors can deduct depreciation from their distributions and thereby defer portions of their tax liability until they sell. We’ve been running an MLP strategy for many years, directly invested in a portfolio of partnerships. This is the best way to own MLPs for high net worth clients.

Recently I’ve noticed a couple of articles discussing how much tax revenue the IRS forgoes through this treatment. A recent estimate from the non-partisan Joint Committee on Taxation put the figure at $1.2 billion annually.  It’s not much in the context of a $3.5 trillion budget, but still worth noting in case tax reform renders this a source of new revenue.

Another interesting development has been the strong growth of various funds (closed end funds, ETFs, ETNs) to hold MLPs for those investors unwilling to deal with K-1s. These vehicles give you a 1099, but the price you pay is a complete loss of the tax efficiency MLPs provide. 1099s come at a considerable cost. Nonetheless, these vehicles are growing strongly. Barrons noted their growth and listed funds that held in aggregate $22BN in MLPs, which is about 10% of the float adjusted market cap of the Alerian MLP index.

Although all these vehicles are only appropriate for smaller investors, their growth is performing a great service to people who continue to invest directly in MLPs and receive K-1s. Because the indirect investors are receiving their returns after tax, the tax loss to the U.S. Treasury is less than would otherwise be the case. Let’s hope that all these funds continue to grow, funded by smaller and less tax sensitive investors.

Nice piece today on BBBY. We’ve liked this stock for a while, strong balance sheet, reasonably priced and exposed to the improving housing market. Barrons probably goes a little overboard in speculating that it’s the kind of name Berkshire (BRK) might choose to acquire, but we think it’s a good investment with plenty of opportunity to generate an attractive return.

Cincinnati Bell (CBB) will celebrate 140 years since its founding this July. It has long provided phone and data communications to residents and businesses in Ohio, Kentucky and Indiana. We have been invested in them for the tiniest sliver of their history, and today endured our very first quarterly earnings release. We were lambs to the slaughter.

The bull case on CBB is that they own a data center (Cyrusone; NYSE:CONE) which represents an undervalued asset. Although their fixed line business is in decline, they have been investing in the data center and in January sold 31% of the company in an IPO. The 69% of CONE that CBB retains is itself worth $975MM, more than the market cap of CBB itself.

The genius in the CONE IPO was that it relieved CBB of the need to continue funding CONE’s CAPEX allowing CBB to pay out excess cash flow as dividends while raising enough capital for the independent datastorage business to self fund growth.  The $390MM of EBITDA that CBB expects to generate in 2013 should need to cover even less capex than 2012 for its legacy business and even after interest and pension fund contributions ought to provide for $100MM to be distributed to shareholders. Since CBB doesn’t pay a dividend, even a $0.25 cent annual dividend ($50MM) on a $4.25 stock would provide almost a 6% yield and draw in dividend investors to drive the stock higher. The once ophan stock of the legacy telco that pays no dividend while investing in datastorage becomes appealing to income seeking investors while their investment in CONE is rewarded in the market by REIT investors seeking growth.

But instead, the company disclosed in its earnings release that it projects 2013 capex at $180-190MM for the non-CONE businesses. The equivalent number in 2012 was $140MM, so they’re increasing their investment into a declining business. The value creation they promised with one hand through the CONE IPO is being hijacked by management with the other. In addition to which, they’re paying certain employees $40-50MM in “IPO success payments”. So far, those are the only people who have made any money out of the IPO.

Fortunately we were not bold and our investment was very small (indeed, smaller after today’s rout). The good news is that the equity in CBB’s remaining business excluding the 69% of CONE they retain is valued at negative $320MM. That’s how the market assesses their decision to quicken the pace of fiber-optic investments and the odds that they’ll generate a return above their cost of capital.

So now it’s over to the activists to impose a taste of corporate democracy on a management team that’s lost the plot. As of December 31 holders included Marcato Capital Management, Gabelli and Lonestar Capital Management. Assuming they retain an investment they can’t be happy with today’s developments. The IPO Success Fee especially grates. We’re holding our small position in the knowledge that more value exists than the company’s current valuation implies while we await a 13-D filing. It might well be an interesting story to follow.

Barron‘s has a decent overview of MLPs today. They could have been more critical of the various funds, exchange traded notes and ETFs that offer MLP exposure. None of these pass through the tax benefits to clients as effectively as a portfolio of direct holdings – although the managers being interviewed run such funds themselves. We also shy away from the E&P names where distributions are more volatile. Low volatility, “low beta” MLPs are better in our opinion.

This call and webcast ended a little while ago. David Einhorn did a very good job of explaining his idea behind ingeniously named iPrefs, only slightly marred by the brain dead questioners who began the Q&A segment. We think the theme of perpetual preferreds is applicable to many companies including tech names such as Microsoft (MSFT) about which I wrote last week. Einhorn’s suggestion highlights the still unmet demand for yield. We certainly hope MSFT takes note but it’s an interesting theme for other companies to consider as well.

This morning David Einhorn on CNBC elegantly highlighted the inconsistency in pricing of different asset classes, specifically in the case of Apple (AAPL), which he owns. Einhorn believes AAPL should exploit the low yields/high prices of preferred equity to the advantage of stockholders.

You can read the transcript of Einhorn’s interview here so we won’t repeat what he said. We don’t own AAPL, but his suggestion isn’t limited to them. In fact, any company with a strong balance sheet, predictable earnings and a low P/E could avail itself of the same strategy.

So we’ve applied it to Microsoft (MSFT), another tech giant that we believe is attractively priced. The basic concept is for the company to distribute preferred equity shares to existing shareholders. No cash would change hands; each shareholder would just receive preferred shares proportionate to their shareholdings. But even though no cash has changed hands, we believe it illustrates how value would be unlocked.

Here’s how it works (my colleague Henry Hoffman crunched the numbers for this example): MSFT has 8.4 billion shares outstanding for a market cap of $228 BN. It has $43BN of cash net of debt (further assuming a 20% haircut to repatriate the cash from outside the U.S.). So the whole company is priced at $185BN ($228BN-$43BN). MSFT pays a quarterly dividend of $0.23, which costs $7.8BN annually. Suppose the company diverted this dividend fully to pay dividends on the preferred shares, which are all owned by existing stockholders. Assuming a 4% yield on these preferreds would value them at $195BN (7.8 divided by 0.04). So the shareholders would own new securities of this approximate value which they could keep or sell in the marketplace. But they’d still own the common equity. Consensus expectations are for MSFT to earn $24BN in the fiscal year 2013 (ending in June). MSFT’s P/E is 7.7X (excluding Cash).

Diverting $7.8BN to pay preferred dividends reduces the net income available to common equity to $16.2BN. Assuming the same P/E multiple on these reduced earnings would value the equity at $125BN. Combined with the preferred equity, the shareholders would now own securities worth $320BN. On this basis each common share would be worth $37.86 on the day MSFT announced its intention to distribute preferred equity securities to every holder of common equity.

It wouldn’t alter the leverage of the company because the preferred would count as equity and would sit just above common in the capital structure. It also wouldn’t alter the company’s dividend expense, since the dividends that were being paid on the common have simply been diverted to the preferreds. It would highlight the large disparity between the valuation of common equity, with an earnings yield of almost 13% (inverse of the 7.7 P/E ratio) and the 4% yield on a security that sits immediately above common equity in the capital structure.

The P/E on the common equity might fall following the distribution of the preferred equity, but even in the absurd case of the common equity being worthless (hard to imagine given $16.2BN of FY 2013 earnings) the preferred equity’s value is still higher than today’s market cap (ex-cash).

You can play around with the assumptions endlessly. One we like is to further assume that money spent on stock buybacks is additionally diverted to preferred dividends. Buybacks count as cash returned to shareholders in the same way as dividends. MSFT’s five year average buyback expenditure is $9.9BN. Adding this to dividends of $7.8BN creates a preferred dividend of $17.7BN and a value on this class of securities of $442BN. Net income left to common shareholders in this case would be$6.3BN in FY 2013.

David Einhorn made a clever suggestion. It’s a neat way to illustrate the discrepancy in asset markets between fixed income yields and earnings yields.

We hope Steve Ballmer was watching CNBC this morning.

Disclosure: We are long MSFT

Money has been flowing into bond funds for a long time. During the financial crisis of 2007-08 many of us contemplated hitherto unthinkable risks to our investments. I spent a few miserable evenings in September 2008 calculating the fall in the value of my own portfolio and wondering where it might stabilize. Avoiding leverage, and leveraged companies, never felt so sensible as back then.

The financial near-death experience so many faced unsurprisingly led to a search for safety through fixed income – a search which has become increasingly price-insensitive over the past year or so as the Federal Reserve has squeezed virtually all the return potential out of bonds. Return-free risk is an appropriate description.

However, some signs are appearing to suggest that the singular focus on bonds is abating. Mutual fund flows have recently confirmed the strong start to the year made by stocks, and since bond inflows remain positive the main source of outflows is money market funds and cash. Figures from the Investment Company Institute (ICI) are likely to reveal the strongest monthly inflows to equity mutual funds in six years when January’s full month numbers are published. Money has been flowing relentlessly out of Equity funds virtually every month since May 2011.

Such figures are often confused with money moving out of public corporations. In fact, the pedantic truth is that for every buyer there’s a seller and cash mostly moves through markets, not in or out. Dollars leave public companies through corporate actions (such as share buybacks or dividends) or through companies going private; it enters through IPOs, secondary offerings, and earnings. So although flows into equity mutual funds won’t show up on corporate America’s balance sheet, they do reflect a more constructive stock market view among retail investors.

Interestingly, a recent report by Towers Watson found that pension plans in most developed countries continued to reduce their equity allocations in favor of Alternatives (clearly not everybody’s read my book) and in some cases bonds. In the U.S. the equity allocation of pensions at the end of 2012 reached 52%, down from 60% in 2007.

But the signs of thawing risk aversion are clearly visible and warm feelings for stocks are more evident than Spring-like weather outside. The Equity Risk Premium, the difference between the earnings yield on the S&P500 and the ten year treasury, has narrowed modestly as rising bond yields have coincided with higher priced stocks. We’re still a very long way from where bonds could be remotely considered a better long term investment than stocks, but near term risks exist as they invariably do. Sequestration on March 1^st is perhaps the most immediate “Made in DC” threat. $120 billion of automatic spending cuts, originally conceived to be so disagreeable as to force an alternative compromise, are looking increasingly likely to take effect unaltered. It is fiscal discipline of a kind, albeit delivered with a blunt instrument. Some observers have noted that greater certainty around fiscal policy is more important than fiscal policy itself, and perhaps by March this will turn out to be true.

Many investors I meet struggle to find the right balance between the mediocre certainty of fixed income returns and the less certain but more probable inflation beating potential of equities. Low interest rates, time and the receding possibility of another financial crisis are all factors. For some it helps to think of Cash as representing risk capacity. Although it earns close to 0%, holding some cash can make the possible volatility of equities more palatable. As mentioned in prior newsletters, a barbell portfolio of stocks and cash weighted according to one’s risk appetite can offer better prospects than a high grade or government bond portfolio.

Within our equity strategies we have maintained low levels of cash over the past few months but recently made a couple of portfolio adjustments. The insurance sector has long been struggling with excess capacity with the consequence that in many cases premiums were not high enough to earn an acceptable return. This has been exacerbated by the very low investment returns available due to low interest rates, greatly reducing the value of the float and highlighting the need for Combined Ratios (which measure the percentage of premiums spent on costs and claims) solidly below 100%. The recent cycle of policy renewals has reflected a “hardening” of the market, and expectations of improved returns on capital have reduced the discount to book value of some names. We exited Aspen Re (AHL), a name we’ve held for a couple of years as it reached 85% of adjusted book value. We added to AIG though, which has the potential to be a good story with improving underwriting profitability and the exit of the Federal government rendering the current price at a 45% discount to book value attractive. We think their cash generating ability will allow continued substantial share buybacks over the next several quarters.

We invested in Bed, Bath and Beyond (BBBY) which is an appealing way to participate in a recovering housing sector. At 11 times earnings and with improving margins we think the threat of online competition is more than fully reflected in the price.

We initiated a position in JCPenney (JCP) over a year and a half ago at much higher prices.  We didn’t anticipate the marketing missteps of 2012 nor the extent of the sharp drop in sales following the removal of promotions and coupons.  However, we still believe the business transformation to a store of many individual shops is the right strategy for the long term.  We have been encouraged by the cost savings achieved, the performance of the initial shops opened last August, the demand expressed for shops from vendors, and the announcement of the return to promotions.  With manageable debt, substantial non-core and real estate assets that could be monetized and $2.5 billion in liquidity, a crisis is not imminent.  Furthermore, two thirds of the shares are owned by people we assess to be long term, high conviction investors and therefore the current record short position of 64 million shares (30% of shares outstanding) is around 90% of actual available float (i.e. shares outstanding less long term holders). A revaluation may occur without many shares changing hands. We increased our position in January.

Income generating sectors bounced back following selling pressure going into year-end. While investment tax rates rose the final outcome was not as bad as many had feared. MLPs in particular had a very strong January following a fairly muted result in 2012. Although January’s performance was equivalent to a plausible one year return, we don’t attempt to make tactical trades in the MLP sector, which would generate taxable realized gains as well as run the risk of being under-invested during a strong market. So we remain fully invested in MLPs and believe the long run outlook remains good although January is often seasonally strong and this January was exceptionally so.

Dividend yielding stocks also bounced back nicely, and our Hedged Dividend Capture Strategy delivered a solid month. Investing for income is still a challenge facing the vast majority of investors, and this theme is likely to be important for a long time to come.

I was fortunate to be in Boca Raton, Florida last week at the GAIM conference on hedge funds, enjoying a 50 degree temperature advantage over NY. I had the opportunity to meet with several retired people who live in Florida either part-time during the winter or all year. Chatting with them about investments really brought home to me the challenge many face of obtaining sufficient stable income on which to live. Bonds purchased years ago are maturing and the replacement opportunities are far less attractive. Equities remain a scary place although the strong start to the year is leading to modestly improved risk appetites. But for many retired baby boomers, they are having to confront significantly lower investment income than they imagined perhaps as recently as 6-7 years ago. There remains a great deal of cash on the sidelines.

Discussions of Master Limited Partnerships (MLPs) were well received. Indeed, MLPs have had a good year already less than a month into 2013, with returns year-to-date that are double all of 2012. Barring a disaster over the next couple of days, January will be one of the five strongest months since 1996 (as far back as the Alerian MLP Index goes). We continue to like MLPs as an investment, although distribution yields of 5-6% with growth rates of 4-6% suggest a long term annual total return of 10-12%. January has pretty much delivered that in one month, so some moderation shouldn’t be surprising.

Dividend yielding stocks have similarly bounced back, as the concerns about investment tax rates that were so pervasive in December turned out to be somewhat more negative than reality.

We have recently made a couple of small sales. Insurance companies have been seeing improved pricing and consequently their discounts to book value have been narrowing. We sold the last of Aspen Re (AHL) as it approached 80% of book value. We continue to own AIG which is still just a little over 50% of book value and looks set to continue shrinking its shares outstanding through buybacks, thus raising its book value. We also sold Republic Services Group (RSG) which we felt was fully valued. We remain constructive on equities overall though, so will be looking for opportunities to reinvest this cash.

At the GAIM hedge fund conference I gave my presentation about my book, The Hedge Fund Mirage. Hedge fund investors largely agreed with my findings (at least, the ones I spoke to) and my conclusions echoed many of their personal experiences. Most of the delegates with whom I chatted agreed that the hedge fund industry needs to make some changes if it is to thrive. My bet is that it will – there are far too many intelligent people with their careers in the business to assume that they’ll fail to adapt to the difficult return environment so many face.

George Soros, who knows a thing or two about hedge funds and how they operate, said in Davos last week that hedge funds couldn’t beat the market because of the fees they charge. He must have read my book.

Here’s an interview I did earlier today, discussing market outlook.

http://reut.rs/W0fL9e

Terry Smith, UK-based CEO of Tullett Prebon AND Fundsmith, LLP (obviously a man of prodigious energy) has written an interesting piece in the FT commenting on the attraction of owning less volatile stocks. He is highlighting the Low Beta Anomaly, a weakness in the theory behind efficient markets which predicts more risky investments need to generate a higher return (to justify their higher risk). In practice, they don’t. The tortoise out runs the hare as the more volatile, momentum-driven names are ultimately overtaken by the superficially boring companies that experience reliable growth. Part of the problem is the use of volatility as risk. If you’re not investing with borrowed money, the fact that stock prices move in value more than the underlying businesses they represent isn’t always a bad thing.

Given interest rate policy designed to relentlessly transfer real wealth from savers to borrowers should they invest in bonds, relying more on equities is sound advice. Although investments that generate income didn’t generate much return during the fourth quarter as we approached the Fiscal Cliff, so far in 2013 the bounce back has been quite breathtaking. Of course the S&P500 is up 4% as I write, but MLPs are up 9%, almost double their entire 2012 return. No doubt their rising prices render them slightly less attractive, although Kinder Morgan (KMI) announced earnings yesterday and continues to see double-digit earnings growth to the benefit of its stockholders as well as MLP investors who own Kinder Morgan Partners (KMP). Perhaps MLPs have a little more ground still to make up after a positive but by no means spectacular 2012. The underlying fundamentals of the sector remain solid.