Our portfolio construction is done on a single spreadsheet where each security in the portfolio is a row and each attribute is a column. EIP believes balancing attributes such as position size, yield, dividend coverage ratio, interest charges as a % of EBITDA, growth, valuation, exposure to each industry segment, regulatory framework, and management ownership enhance the practice of portfolio construction. EIP views portfolio construction as just as important as security selection. It matters not how many “good picks” we have in our portfolio, but their size and the size of the bad picks as well. What matters is the total return of the portfolio, its underlying risk, its volatility, and its covariance with other asset classes (see the “Analysis of Returns” section for a discussion of volatility and covariance of our portfolio).
EIP believes there is a difference between risk and volatility of security prices. When we think of risk, we think of the underlying business and how that business is formed, its balance sheet, capital spending behavior, and how it performs in terms of its earnings dividends. Companies with too much leverage, uncompetitive assets and cyclical cash flows are at risk of going bankrupt regardless of how volatile their stock prices have been in the past.
EIP seeks to manage risk in its portfolio on two levels: The first is by identifying companies that have the types of characteristics that offer good prospects for returns relative to risk. EIP believes that in the energy industry companies with higher payout ratios of earnings that are derived from non-cyclical infrastructure assets generally offer these characteristics. As described in the Investment Process section, EIP also believes that eliminating companies of low quality is a critical step in reducing the portfolio’s risk. EIP does not believe that a “cheap” valuation sufficiently mitigates the risk of including a poor quality company in the portfolio.
The second way we manage risk is through the portfolio construction process also described in the Investment Process section. EIP attempts to diversify its portfolio holdings across sectors such as petroleum versus natural gas pipelines, pipelines whose primary value is driven by sources of supply versus pipelines whose value is driven on the demand end. Diversification across geography is also taken into consideration as geographic concentration could inadvertently lead to overreliance on one source of supply or demand or regulatory risk. Finally, an outgrowth of EIP’s approach is diversification across asset classes such as MLPs, state-regulated utilities, pipeline corporations and Canadian infrastructure trusts and their successor companies.
Industry Segment Concentration
Portfolio risk can also result from too much concentration in a particular industry or industry segment. EIP measures the exposure of each of its portfolio companies to over 15 industry sub-segments. If a company’s predominate exposure is to natural gas transmission pipelines but also has exposure to gathering and processing, we do not categorize the company as simply “gas transmission” (which is a regulated and steady business). This would hide the company’s exposure to an unregulated cyclical business. Instead we breakout the portion of the company’s EBITDA to each segment. By multiplying these exposures by the company’s position weighting in the portfolio, then adding them up for all of the companies in the portfolio, we can estimate the portfolio’s overall exposure to each sub-segment.
Asset Class Exposure
The industry segments that best fit EIP’s strategy have stable cash flows from utility-type monopolies housed in equities with high dividend payout ratios. These segments include Pipelines, Storage, Terminals, and Electric Power & Transmission. There has been much growth in the MLP category from assets moving into the MLP structure (and more recently YieldCos) from either the C-corp or the utility structure as well as the building of new pipelines, gathering and processing assets, etc. In essence, the energy industry has been restructuring itself in a way that separates non-cyclical businesses that can support a high payout from cyclical energy businesses which cannot.
By focusing on the merits of infrastructure companies with high payout policies, EIP is not bound to a single structure, category or sector such as MLPs, income trusts, or utilities. EIP is agnostic as to which asset class its portfolio is constructed from.
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