One of the fun things about being a personal finance blogger, is it really keeps you learning and looking for new things to learn. It also gives me opportunities to invest in some things that my wife might say no to if I didn’t convince her it would be fun to talk about on the blog. Master Limited Partnerships (MLPs) might end up being just that sort of thing.
What are MLPs?
Most publicly traded companies are corporations (C Corps for tax purposes, to be exact). If you’re going to be a publicly traded company, you have to be a corporation in most cases. The problem with being a corporation is that if you plan on paying a distribution or dividend, you’re going to be taxed on the money you earn twice. Your business entity gets taxed on any money they make at the entity level, then the earnings get taxed if and when they’re distributed to the shareholders.
In the 1980s, Congress allowed certain types of companies to be public traded but be partnerships instead of corporations. The main advantage a partnership has over a corporation is that partnerships are “pass through” entities for tax purposes. This means that the company doesn’t pay any tax at the entity level. Distributions are still taxed, but this avoids the problem of double taxation that most publicly traded companies face. Congress intended MLPs to be used to encourage investment in natural resource company. Of course, if something looks advantageous, other companies are going to try to do it as well, so Congress eventually had to tighten their regulations.
When this tightening occurred, the new law required that any company designated as an MLP had to produce 90% of its earnings from “qualified resources” (natural resources and real estate). Most MLPs are involved in energy infrastructure, i.e. things like pipelines.
What are the investment advantages of MLPs?
1. Their unique tax treatment.
2. Consistent distributions – MLPs are required to pay minimum quarterly distributions to limited partners. This is established by contract, so distributions are predictable. Otherwise the company could be found to be in breach of contract by its shareholders.
3. Energy infrastructure earnings aren’t that closely correlated to stocks, bonds or the price of oil or commodities. They’re tied more overall demand for energy.
4. The yields tend to be pretty high. For example, Linn Energy (LINE), a MLP and a Seth Klarman holding (though he’s reportedly been cutting his stake) currently has a yield around 13%.
What are the risks of MLPs?
1. Risk of regulation or change – the government could step in and change the rules of the game. That can always happen. Since one of the main advantages of these babies are there tax advantages, this poses a considerable risk for an investor.
2. Interest rate risks – It’s commonly thought that these types of investments do better when interest rates are low, making their yield higher in relations to the safest investments, such as Treasury bills and securities that are guaranteed by the US government. Right now rates are very low, but if rates on T-Bills went to 5%, the average 8% rate that MLPs carry won’t look quite so attractive.
Should You Invest and How?
Should you invest in MLPs? I have no idea. I have no idea what the market will do. I think in most cases, a greater return indicates more risk, at least in the short term. Seth Klarman, however, has been investing in MLPs for several years now, and he’s an expert in identifying situations where the return is greater than the risk offered by the situation. He’s one of the most conservative and successful investors out there (he often keeps half of his hedge fund in cash). He’s been tied to both LINE and Breitburn Energy (BBEP).
BBEP recently cut their yield and most sites don’t indicate this, so be careful if you try to follow Klarman in. Another way to invest in MLPs is through an index fund. I know S&P has one. I’m sure some of the other big players in index funds do, too. If they don’t, they will eventually.
I’d be remiss if I didn’t point out that this is not contrarian play. You aren’t going against the grain with this one. MLPs are a popular thing to be in right now. This could cause the prices to be inflated. They don’t look inflated to me, relative to earnings. LINE is trading at less than 2 times earnings. Of course, I haven’t really looked closely at these stocks. I don’t own them, but I’m planning on taking a close look at several MLPs soon, starting with the ones tied to Klarman. Good luck. If you make a bundle investing in MLPs, please remember to donate half the profits to this blog;) Thanks for reading.
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