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An MLP exodus may soon end
MLPs also were oversold because hedge funds and momentum investors -- who buy stocks with big earnings and share-price gains because they expect more of the same -- had large positions. They've been selling off those positions, Murchie says. And because the shares of many MLPs trade in relatively small numbers each day, the prices have been overly punished by this exodus.When will this group turn around? I don't know, and nobody else does for sure. But that's OK. With MLPs, it takes time to profit from one of the true benefits: the tax deferral. So these should be viewed as long-term investments anyway.
To see why, let's delve into how MLPs work, with help from Jonathan Gassman of Gassman & Golodny, a financial-planning boutique and investment shop in New York City.
The nuts and bolts
When you buy an MLP, you become a limited partner. This means that each year the MLP has to distribute excess cash and profit to you. These distributions take two forms: a return of principle and a share of partnership income.The share of partnership income, typically the smaller amount, gets taxed right away.
In contrast, you don't pay tax on the return of principle. Instead, the cost basis on your initial investment is reduced by this amount. This means you won't pay tax on this income until you sell the original investment. A nice feature: You can put off paying taxes on most of the money earned via your MLP for as long as you want simply by holding on to the original investment.
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- You can't hold MLPs in tax-sheltered accounts such as individual retirement accounts.
- The paperwork is a mess. You'll have to deal with complex forms that often don't arrive until right before April 15. So you may have to file for an extension. And because energy pipelines can run through many states, you might have to file tax returns in several states. "As a financial planner, I love MLPs because of their yield. As an accountant, I hate them," Gassman says. "They are just a nightmare."
MLP plays
If you don't want to mess around with individual partnerships, you can buy shares of a closed-end fund, Energy Income & Growth (FEN, news, msgs), that is run by Murchie's shop. Energy Income Partners just took over management of the fund in September, so don't hold it accountable for performance before that.As for specific MLPs, I'd suggest those insiders have been buying in significant amounts lately -- like the ones in the chart below. According to data provided by Lehman Bros. (LEH, news, msgs), all of these have sufficient cash flow covering distributions to be considered reasonably safe.
High-yield MLPs where insiders are buying:
| Yield | Yield growth* | Share price** | Price target*** | |
|---|---|---|---|---|
Natural-gas gathering and processing (pipelines and plants): | ||||
10.4% | 7.4% | $30.34 | $42 | |
10.0% | 13.7% | $24.59 | $37 | |
9.0% | 20.0% | $23.72 | $31.50 | |
8.6% | 9.7% | $29.86 | $40 | |
7.5% | 13.5% | $34.08 | $41 | |
Natural-gas pipelines: | ||||
9.5% | 2.7% | $18.10 | $24 | |
7.1% | 6.3% | $59.89 | $66.50 | |
Pipelines and terminals for refined petroleum products: | ||||
8.8% | 7.3% | $33.74 | $43 | |
8.3% | 4.6% | $42.90 | $52 | |
7.2% | 9.9% | $55.69 | $63 | |
Crude-oil pipelines and infrastructure: | ||||
7.7% | 7.3% | $47.47 | $55 | |
Exploration and production: | ||||
12.7% | 12.5% | $16.40 | $23.50 |
*Annual three-year growth in distributions to unit holders (projected by Wachovia). **As of Aug. 28. ***12-month consensus Wall Street analyst price target (from Thomson Financial). ****This is a limited partnership that pays dividends in the form of KMR shares, gains from which get taxed as long-term capital gains if you sell after holding for more than a year.
Safety and risk
All but one of the MLPs above operate in energy infrastructure, as opposed to energy production or shipping. This means they are relatively safe for two reasons:- They aren't affected too much by unpredictable changes in energy prices. They are simply toll takers paid to move energy around, not buy it or sell it.
- Many of their fees are set by regulators. This makes their income more predictable.
But there are risks:
- Lawmakers might take away some of the tax advantages, points out Deutsche Bank (DB, news, msgs) analyst Paul Sankey. I don't know of anyone who expects this, but it did happen recently in Canada.
- If the Federal Reserve starts raising interest rates, that could hurt MLPs as yield players shop elsewhere for better returns.
- A really sharp economic downturn could reduce energy usage enough to leave some MLPs with excess capacity.
At the time of publication, Michael Brush did not own or control shares of any securities mentioned in this column.
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