One thing we believe in at The Oxford Club: You shouldn’t pay any more taxes than you have to. Of course, you must follow the law. But there are great ways to grow your investments, generate income and reduce your tax bill dramatically… legally. Today, I’m going to talk about one of my favorites.
Master limited partnerships (MLPs) offer tax-deferred income in an investment that has the liquidity of stocks. My colleague Marc Lichtenfeld wrote a great article on the tax benefits of MLPs.
But how do you decide which MLPs to purchase?
Not All MLPs Are Created Equal
Investors who look at MLPs are interested in three things. The first is distributions. The second is distribution growth. Finally, share growth of the MLP itself.
The table below lists five popular MLPs (all of them are in the energy sector), their annual distribution yield and their corresponding distribution increase – on a quarterly and an annual basis.
If we just compare yields, we might be tempted to buy shares in American Midstream Partners. But we’re interested in distribution
growth. Using that metric, we might pass on American Midstream. In fact, as we’ll see below, it’s more likely that American Midstream will have to
cut its distribution in the near future than raise it. Targa Resource Partners is in the same boat.
Summit Midstream Partners just went public last winter, so there is no year-over-year comparison. However, Summit has the second-best performance of any MLP year-to-date. Its total return is over 80%.
While Kinder Morgan Energy Partners had a slightly negative annual unit growth, it’s one of the largest and most stable MLPs in existence. It’s also raised its dividend for 48 straight quarters. No other MLP has matched this run.
A Love That Lasts
As important as distribution growth is, the MLP’s ability to maintain that growth is even more vital. The best way to measure sustainability is to look at the distribution coverage ratio.
The coverage ratio is simply the quarterly distributable cash flow (DCF) divided by the paid distributions. We’re looking for a ratio greater than 1 – the higher the better. Look at the table below to see how they stack up. DCF and paid distributions are in millions of dollars.
Targa Resources Partners and American Midstream Partners have a coverage ratio of less than 1.
This is a clear indication that their dividends are unlikely to go up. In fact, it’s an indication that they’re likely to decrease. In Targa’s case, the company’s management expects to finish 2013 with a coverage ratio above 1.0. We shall see.
Summit is demonstrating that even after a 4% increase from its first quarter payout, it’s generating lots of cash. The company’s dividend seems safe.
But what about Company X? It’s clear from the chart that Company X is generating much more cash than it’s paying out. It’s no wonder its units are up 27% so far this year.
It’s a good bet that Company X’s unit growth has a lot to do with its distribution growth. More important: It’s because of the company’s ability to
cover its distributions. It’s one of the best-run MLPs in the energy sector.
Why doesn’t Company X just pay out more cash? This MLP’s management runs its business cautiously. They have decided to pay out less in the name of safety of the business.
So, Who Is Company X?
In fairness to the subscribers of my energy and infrastructure newsletter,
Peak Energy Strategist, I can’t tell you. It’s one of the best-performing stocks in our portfolio.
Right now, we have a mix of high-yielding MLPs, as well as some high growth stocks in the energy and infrastructure sectors. If you want to learn more about
Peak Energy Strategist, you can click
here.
Today, investors have more MLPs to choose from than ever. But as you can see from the analysis above, you must be extremely fussy. Taking the time to calculate an MLP’s coverage ratio can help you sort the strong performers from the also-rans.
Please note that this article also appeared in Investment U.
https://www.investmentu.com/