Master Limited Partnerships, or MLPs, are making a comeback with investors. With juicy yields north of 8%, it’s hard not to take notice.
Barron’s is so bullish on the investment sector that it has actually named it its best investment idea for 2019.
This could be a good time to reconsider the sector, which has an average yield of 9%. The energy-pipeline industry is probably in its best shape ever, thanks to growing cash flow, rising domestic energy production, and improving corporate governance.
But what exactly is an Master Limited Partnership, anyway, and is it the right fit for your portfolio? Learn more below.
The basics of MLPs
Master limited partnerships are a type of business entity that is taxed as a partnership. Within this business entity are mostly oil and gas companies.
These are publicly traded stocks that trade on major stock indexes, such as the New York Stock Exchange. MLPs range in size from $500 million market cap to as high as $30 billion or more. There are close to 100 publicly traded MLPs, according to the MLP Association.
MLPs aren’t as dependent on oil and gas prices as non-MLP producers, such as Exxon Mobil. That’s because MLPs are mostly midstream companies that operate a fee-based business model, meaning they’ll earn a set fee for each barrel of oil or cubic foot of gas that is transported or processed. This results in predictable cash flow.
Key differences from corporations
Your Apple and Disney stock may be incorporated, but not MLPs.
- “Shares” are instead called “units.”
- Dividends are called distributions and dividend yield is referred to as distribution yield.
- You’re not a shareholder. You’re a limited partner, and as a partner, you’ll receive distributions (typically paid quarterly).
- MLPs do not pay federal income taxes, unlike corporations. But to receive this key benefit, it must generate at least 90% of its earnings from activities related to natural resources, commodities or real estate.
- You’ll receive a K-1 tax form (Form 1065) in the mail instead of a 1099 form. This is to report your share of income.
Pros to MLPs
Here’s why you can earn impressive returns in this sector. I’m a big fan: as of writing, they make up close to 10% of my total net worth.
- Strong yields. By far the best part of owning MLPs is the incredible yield they can provide. The Alerian MLP index pays a yield of 7.86% (as of Feb. 2019), compared to a 3.83% yield in real estate investment trusts (REITs).
- Dividend growth potential. Several MLPs have a strong track record of increasing distributions year-after-year. For example, Enterprise Product Partners has grown its distribution for 20 years running, according to Dividend.com.
- No federal income taxes paid. Since MLPs do not have to pay federal taxes, they have more money to pay out to investors. In fact, MLPs typically pay out most (if not all) of its cash flow to investors.
- Predictable earnings. MLPs aren’t as dependent on oil and gas prices as non-MLP producers. That’s because MLPs typically operate a fee-based business model and get a fee for each barrel of oil or cubic foot of gas that is transported or processed.
Cons to MLPs
MLPs aren’t for everyone and there are several drawbacks to be aware of.
- Complicated tax structure. I can tell you firsthand that it is a pain to file taxes on MLPs. My accountant charges more to file my taxes ($500+) because I own seven different MLPs! She has to fill out K-1’s for each holding. There’s no way I can do it myself.
- Limited appreciation upside. You can make an argument that MLPs do not have the same kind of upside as other sectors, such as tech and consumer goods. You’re not going to find the next Amazon, and the Alerian MLP index is trading at the same price it was 5-6 years ago. However, I would argue that investors should buy MLPs for the income and not the appreciation.
- Poor recent performance. MLPs have not made for the best investments in the past. The Alerian MLP fund returned a negative 12.6% in 2018, in a year in which the stock market fell by 6% (S&P 500).
- Not a good way to diversify. These are mostly oil and gas companies, and midstream companies in particular, which is a business that transports, stores and processes oil, gas and natural gas liquids.
- You should not own in a retirement account. Holding units in an IRA can create an unrelated business taxable income, or UBTI, when that income exceeds $1,000 in a year; you would lose the tax benefits of the IRA and face a tax rate of 39.6%.
How to choose MLPs and top picks for 2019
So how do you choose the best MLPs to invest in? In my opinion, go for the companies that have a solid track record of increasing distributions, even through recessions.
I personally focus on companies that are growing their distributable cash flow, which is money available to be paid as distributions to its limited partners once general partners have been paid. You’ll want a company that can easily coverage its distributions – aim for a distribution coverage ratio of 1.2X or higher.
I also don’t like investing in MLPs that are highly leveraged with excessive debt; I try to avoid those with high debt levels as those companies may run into trouble if commodity prices tank or if production is somehow disrupted.
Other factors to consider include: growth potential, quality of assets and management team, and access to capital markets (smaller companies may have trouble getting financing, for example).
Here are some top picks for 2019.
3. MPLX, LP (MPLX): This is a $25+ billion dollar MLP that owns and operates midstream energy infrastructure and logistics assets. Units currently yield just under 8%.
2. Phillips 66 Partners (PSXP): Formed by its parent company Phillips 66, this MLP owns and operates fee-based crude oil, refined petroleum product and natural gas liquids pipelines. Units yield 6.8% as of writing.
1. Enterprise Product Partners (EPD): With a market cap topping $60 billion, EPD is one of the largest MLPs in the world and ranked No. 105 in the 2018 Fortune 500 list. Enterprise owns more than 50,000 miles of pipelines in the U.S. Units yield 6.3%.
Disclosure: I own units of EPD, PSXP and MPLX. This post is for informational purposes only and should not be read as professional financial advice. I am not a financial advisor or planner. Please do your own due diligence before investing and consult with an advisor or accountant.