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This is a two-part introduction to the Master Limited Partnership. Read How to Invest in MLPs, Part One.
Because of the special nature of MLPs, there are two things that you do not want to do when you purchase them.
First of all, do not put them in a 401(k) or in a traditional IRA. This will not only create a tax nightmare, but it also negates one of the primary reasons why you want to buy MLPs in the first place: for the tax-deferred income.
You do not want to put a tax-deferred investment inside an IRA. It makes no sense, and can lead to higher taxes when you withdraw. Trust me – just don’t do it.
The second thing you do not want to do is to buy into MLPs via a mutual fund or ETF. While such a fund offers instant diversification, there are several drawbacks. The ETFs come with yearly management fees, that cut into your investment every year. And consider the fact that ETFs may sell their individual holdings whenever they want; this will contribute to capital gains that the ETF recognizes, and that you will have to pay taxes on.
If you hold individual MLPs in a taxable account, you will pay only brokerage fees to purchase them, and only minimal taxes while you hold them. If you don’t sell, you don’t pay the capital gains tax. It’s completely up to you.
The same criteria that I defined for analyzing and selecting dividend stocks can also be applied to MLPs. You want one with a good history of paying and raising its distributions, so you will be looking at its distribution- history as well as its 5 or 10-year Distribution Growth Rate. It’s not uncommon for an MLP to raise its distribution EVERY QUARTER.
You also should examine the unit share price. Has it been growing over the past couple of years, or is the distribution yield high because of a falling price? What is the partnership’s projected five-year growth rate? And is the partnership fairly valued, i.e., how is the PE in relation to its history and in relation to other MLPs?
The only metric that is different for an MLP is the payout ratio. If calculated like a dividend stock, it would be distribution divided by earnings. However, many MLPs are able to pay out more than 100% of earnings, thanks to the depreciation and other factors.
Better metrics are the distributed cash flow (DCF) percentage and the cash flow coverage ratio, which are actually two sides of the same coin.
The DCF takes revenues minus expenses, and then strips out the depreciation, amortization, and other non-cash items. What remains is the actual cash that is generated by the business, which is available for distribution to the partners. This number should ideally be somewhere in the 70-80% range.
And flipping that number into a coverage ratio, by dividing the current payout by the total per-unit DCF, gives the amount of “cushion” that a partnership has in paying out its distribution out of free cash flow. That number should be in the 1.3 and up range.
Although these companies are part of the energy sector, they are usually the pipeline and transportation/storage businesses, rather than the exploration or production businesses. This means their unit prices are not so heavily dependent on the price of the various energy components like natural gas and oil.
Don’t be afraid of what you don’t know – these investments promise great returns, and they aren’t too scary, as I hope I’ve shown.