MLPs Can Add Energy to Your Portfolio

08/21/2012 8:45 am EST

Focus: MLPS

More and more yield-seeking investors have been turning to master limited partnerships for yield. Greg Reid of Salient tells MoneyShow about the growth he sees going forward in this energy-sector investment.

Kate Stalter: Today, my guest is Greg Reid. He's managing director of Salient Partners, and also the CEO of Salient Master Limited Partnership (SMF). Greg, let's just start off with the easy question today to set the stage. Explain for our listeners what a master limited partnership is, and what the advantages may be.

Greg Reid: Sure. A master limited partnership is a publicly traded energy infrastructure company, which means they're typically involved in pipelines, natural gas, and crude oil distribution and storage-a variety of energy related distribution businesses.

This is an asset class that has 80 public companies, and approximately two thirds of the market cap is based down here in Houston, where we're headquartered. It's more of an energy-centric type asset class, but these are publicly traded limited partnerships.

Kate Stalter: Explain for our listeners if this is something that they are unfamiliar with. A lot of people are somewhat aware that these are dividend-paying vehicles, and they get intrigued on that level. But what else should investors be looking for in these vehicles?

Greg Reid: What makes MLPs very attractive, I think, for all types of investors, is they do pay out most of their cash flow in the form of distributions, essentially their dividends. The current yield is approximately 6.25% in the industry now. We use the Alerian MLP index as the best index, and so roughly a 6.25% current yield.

What's really interesting is most of that income is tax-deferred return of capital. So the after-tax return is very high. And these companies are growth companies, meaning they grow their cash distributions on average about 6% to 7% per year. So investors have gravitated towards this space because they've enjoyed returns over the last decade that have been about 16% a year.

It's really a pretty simple formula of current yield of 6.25%, plus growth of 6% to 7% a year. That adds up to an expected return between 12% and 13% a year. So that's what has caused these assets to be popular. And of course we're in a yield-starved world-people looking at ten-year Treasuries at 1.7% are naturally drawn to an instrument that yields 6.25% and offers them not only growth, but also some inflation protection.

That inflation protection is the last piece. They own real assets: we call them pipelines, storage facilities. They're all hard assets; therefore, they cost more to build in an inflationary environment, and as inflation ultimately does pick back up, we expect MLPs will provide a nice inflation hedge for investors and their portfolios.

Kate Stalter: Are these particularly liquid investments? What's the story there?

Greg Reid: They're definitely liquid. They're publicly traded, primarily New York Stock Exchange stocks. They tend to have a little bit less liquidity than a typical common stock, and the reason is because of the tremendous tax benefits most investors are buy and hold. They don't want to trip the capital gain and recapture any income when they sell.

So you find most investors kind of take a buy-and-hold approach. That creates less turnover, and that I think has been a factor for some institutions. But really for most individuals, they're plenty liquid, where they could sell their entire portfolio in the same day if they wanted to.

Kate Stalter: Now let's talk a little bit for a moment then about some of the companies in this space that you particularly like.

Greg Reid: Sure. I'd be happy to. As I mentioned earlier in Houston, where we're headquartered, you have about a third of the MLPs headquartered here, but almost two-thirds of the market cap, because Houston is really the headquarters of the energy industry.

So I'm going to talk about a few Houston companies. One of our favorites is Plains All American (PAA). This is a crude oil-related partnership in the sense they have transportation and storage of various crude oil products throughout the country. It's been a tremendous performer over the last decade, providing returns of around 19% a year.

Just recently, as in yesterday, they announced a 2:1 stock split. So the stock is trading for around $88 a share, it yields about 4.9%, and they're getting ready to split the stock on October 1. That's an example that that company has been growing very nicely.

It's a very healthy growth company. Growth is approximately 6% to 7% a year and the yield is approximately 5%, so it kind of fits our description of an attractive low teens-type expected return. So that's an excellent core holding example in our portfolio.

We also have Enterprise Products Partners (EPD). They're a Houston company. They're actually the largest company in the industry and just an excellent overall business. They're very diversified, large cap, investment grade. This is a company that is growing at around 7% a year, as well.

I think most importantly with them, they have a tremendous amount of capital improvement scheduled over the next several years that will enable them to not only grow 6% to 7% a year, but maintain that growth rate for the foreseeable future. This company yields around 4.8%, as well. So those are two examples of core holdings in our portfolio.

Then what we typically do is we would look for other small-cap to mid-cap companies that are growing at a higher rate we think than some of the large-cap names. An example of that is Targa (TRGP). This is another company here based in Houston that has both a limited partnership and a general partnership. We own both of those in our portfolio.

Targa is in the gathering and processing part of the business, which means that they have gathering and processing facilities in the various shale plays throughout the United States. As those shale plays discover more crude oil and natural gas/natural gas liquids, there is a greater need for distribution, storage, and manufacturing in that business.

So Targa has enjoyed very high growth, and they're growing more in the lines of 10% to 12% a year at their limited partner, and approximately 25% to 30% a year at their general partner. In that case, you have two classes of shares: you can actually buy the LP or the GP.

That's one of the unique things about the master limited partnership industry, is you have not only limited partners trading, but in some cases you have publicly traded general partners. Typically, you're going to have a lot higher growth and a lower yield at the general partner level.

So you really have to do your homework to figure out what's the business worth and what are the growth trajectories for the businesses, and then figure out what you're willing to pay to determine whether or not it's a good value today or not.

Kate Stalter: Or have a fund manager make these selections for you.

Greg Reid: That's right. That's what we do. We have a nine-person investment team, a number of CFAs that do our own proprietary models to figure out what these companies are doing, and how to pick the best stocks. Ultimately, we have a portfolio of really 25 of these MLPs that comprise our portfolios.

Kate Stalter: Greg, last question for you today. You've given us some fantastic information, but just looking ahead: At this point in time, there's a whole lot of doom and gloom and discouragement about the economy. We're in an election year, so you're going to be hearing more of this than usual. But what do you see as the outlook for this particular sub-sector of energy in the United States?

Greg Reid: Well, your point is well taken. There is definitely a lot of pessimism about the economies in the United States and around the world, about government and all the deficit spending.

That being said, there's a very solid financial growth story here in the MLP space. It's not as well understood, I think, by many investors.

So what I'm talking about is that we've already had a renaissance going on in America today, in terms of oil and natural gas production. That is going to create a tremendous need over, say, the next 25 years for energy infrastructure. So really what MLPs are doing is, they're building the pipelines, storage, and distribution facilities for the next 25 years.

At the end of the day, the US economy and US population growth is what drives energy demand. As long as there is population growth and some economic growth, it might be lower on the order of 1% to 2%, but that creates very healthy energy demand and you're going to need more transportation and storage.

MLPs really are in the business of providing that essential service. We call it a toll-road service, where you get paid a fee primarily for distribution and storage. That's a very healthy environment.

So we see in the MLP space annual growth of around 6% to 7% for the next several years, and when you combine that on top of the 6% yield, you're looking at a low teens expected rate of return. Which looks very good compared to most other asset classes that struggle more with either low yields or economic growth being below expectations, and so investors get discouraged and move into cash or into bonds.

Related Reading:

A Smart MLP for the Short Term

5 Asset Classes for the Second Half

An ETF Alternative to Pesky MLPs

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