Description

There are several reasons why this investment looks appealing to me. From a short term perspective the primary reason is the increased discount to NAV that developed in the last couple of months especially compared to the other closed-end energy infrastructure MLP’s.
For those of you that have owned partnership units in MLP’s in the past, you have had to deal with two negatives. First you had to content with the hassles of receiving a K-1, and secondly, if you wanted to invest the assets in a retirement account you ran into the dreaded UBIT. Investors often avoid purchasing MLP’s the last few weeks of December to avoid having to deal with a K-1 for only a few weeks of ownership. This factor along with tax loss selling can create some short term weakness in the prices of MLP’s. The advantage to the MLP structure is that they do not have to pay taxes. They pass most of their often substantial cash flow directly to shareholders, who technically are partners. Those annual cash distributions also have tax deferral advantages because they largely constitute a return of capital rather than income. Because MLP funds pay taxes, they should yield less than a do it yourself MLP portfolio. In addition the managers are not going to work for free so that shaves another 1-1.5% per year. But like closed-end bond funds, the MLP funds try to offset that disadvantage by borrowing to leverage their assets (FMO currently employs approximately 30% leverage). They can also invest in private placements and other non public obligations.
While I’m not a fan of paying fees and using leverage, I am willing to accept it at the current discount to NAV (-11.92 at the $17.29 year end price). While it is possible that the discount could reach 15%, the risk of a material increase in the discount is negligible at this point. The annual yield on the current dividend is 7.24%. If FMO was trading at a 2% discount like it was in May of ’05, the yield would only be 6.5%. For those investors that are struggling to find dividend income with payouts that have grown throughout the years, I think that FMO fits the bill. One analyst has calculated the historic average annual growth rate for MLP distributions at 5%.
For investors looking for an investment that offers some diversification to other equities, the correlation of MLP’s to the S&P 500 Index is in the 25-30% range.
80% of FMO’s investments are in midstream energy infrastructure. Midstream energy assets are mostly oil and gas pipelines, processing, and storage facilities. The focus in this area is getting paid to move the product to the end user and not being as exposed to the commodity risk. While it’s difficult to predict the short term energy price outlook, it is a safer bet to continue to believe that energy demand will grow.
There was quite a bit of investor interest in this area at the end of ’04. FMO had a public offering in late 2004 at $20. In ’04 an MLP composite index generated a total return of 24.4% versus the S&P 500’s 10.9%. Year over year distribution growth averaged 7.9%. From 2002-2004 the composite produced a total return of 19.4%. If you go back to the year 2000, the return is even higher. This obviously contributed to the reason that some of the closed-end MLP’s even traded at a premium to NAV during the first half of 2005. I also believe there is a strong appeal to older investors that want yield in their retirement accounts and appreciate the characteristics of this type of investment

The other three closed-end MLP funds are:
Energy Income & Growth (FEN)
Kayne Anderson (KYN)
Tortoise Energy (TYG)

KYN and TYG only publish their NAV once per month but the current discount to NAV should not be steep as FMO. FEN was only trading at a discount of just over 2% to NAV at year end. I don’t see enough of a performance or risk difference for FMO to be selling at the current discount to NAV compared to the other closed end MLP’s.
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Risks:
If rates keep rising this would have a negative drag on FMO.
If there is a big energy sell off, FMO could be affected by the negative sentiment.
If there was a dramatic shift in tax policy that forced MLP’s to begin paying a corporate tax.

Catalyst

Narrowing of the discount to NAV compared to the other funds.