Why I Like MLPs

04/18/2012 1:31 pm EST

Focus: ALTERNATIVE INVESTMENTS

Roger Conrad

Founder and Chief Editor, Capitalist Times

There is no one perfect investment. Nor do dividend-paying stocks exist that carry no risk or have limitless growth potential.

Selected master limited partnerships today, however, stack up about as well as anything on all of those measures. And they enjoy a rare tax advantage that could become a lot more important next year, should Congress fail to extend the maximum 15% tax rate on dividends.

To be sure, MLPs aren’t as cheap as they were in early 2009. Even as recently as early October 2011, the broad-based Alerian MLP Index had a value of 340, or 20% less than by spring 2012.

What most investors don’t know, however, is much of the money invested in MLPs in recent years is from institutions and has gone into many of the same names. That’s left a large number of companies on the bargain rack.

In fact, I know of an MLP yielding more than 7% that has increased its distribution for 31 consecutive quarters. That’s a string that goes back to 2004. And virtually all of its revenue comes from simply collecting fees for transporting and storing refined petroleum products.

That’s a business nearly as reliable as operating a regulated electric or water utility. And unlike with an ordinary common stock, you’re not going to pay any current tax on most or even all of its distributions, depending on the year. Rather, what you receive comes off your cost basis, so you only pay taxes when you sell.

Two questions I get a lot from readers of MLP Profits—which I co-edit with Elliott Gue—are whether or not MLPs can continue to grow their distributions as fast as they have in recent years and whether their tax status will be changed next year.

The pipeline company I teased about above, for example, has been growing its payout by more than 5% a year. And another MLP I know that also specializes in oil transportation has been consistently growing its dividend at an annualized rate of more than 10%. In fact, it’s done so for 22 of the past 27 quarters.

That’s truly extraordinary growth, particularly when you consider these companies already pay dividends of 7% and 6%, respectively. The best thing about them, however, is they still have a tremendous opportunity to keep buying and building new facilities, which in turn boosts their revenue, cash flow and dividend distributions.

The key is the rapid development of oil, natural gas, and natural gas liquids from North America’s shale reserves. Growth has been so robust that natural gas prices were driven to 10-year lows this spring, as supplies have temporarily overwhelmed demand. That won’t last forever, as electric utilities replace coal with gas power. Facilities to export liquefied natural gas are also gearing up and, for the first time in half a century, major global industrial companies are building factories here.

Meanwhile, there’s still a critical shortage of pipelines, processing facilities and storage for getting this energy to market. And MLPs are ideally suited to filling the gap, thanks to growing scale, access to the lowest-cost capital in half a century and a lock on the business of super oils, arguably the world’s most creditworthy companies.

The key is to know the MLPs you own inside and out, so you can make sure they’re executing. But so long as management takes care of business, we’re looking at robust dividend distribution growth for many more years.

As for taxes, one reason I like participating in conferences like MoneyShow’s special events on master limited partnerships is I can listen to people who are better connected than I am. My view is after the November presidential and Congressional elections, there’s going to be a lot of pressure on politicians to do a deal on the federal budget, and that could well include a higher tax rate for ordinary dividends.

MLPs, however, are a poor target for raising revenue, as any new tax would raise miniscule new funds. The industry also has many friends on both sides of the aisle who have faced down tax proposals in the past.

I admit this is an unknowable. Every investment has risks and that’s why no one should invest 100% in any one sector, including MLPs. But even in a worst case, the best MLPs will have opportunities to grow. That’s the key to big-time investor returns, no matter how they’re taxed. And the future looks very bright indeed.

Roger S. Conrad is co-editor of MLP Profits with Elliott Gue. He’s also editor of Utility Forecaster—named this year to the Hulbert Financial Digest’s Honor Role—and Canadian Edge, co-editor of Big Yield Hunting and Australian Edge, and an associate editor of Personal Finance. To sign up for his free weekly commentary “Utility and Income,” visit www.RogConrad.com.

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