The Linn Energy 2-Step: Reinvest, Then Stop Reinvesting

Jul.29.14 | About: Linn Energy, (LINEQ)

Summary

While portfolio construction typically begins with owning the highest-quality names first, I wanted to outline a strategy that begins with selecting high income generating companies initially.

Someone who has owned Linn Energy and reinvested the distributions over the past five years would now have an annual yield-on-cost of over 30%.

After reinvesting for a period of time (such as five years), it can be an act of prudent risk management to take those distributions and deploy them elsewhere.

One of the reasons why income investing is an art as much as a science is that investors must balance the simultaneous desires to own assets that produce high current income, offer high growth of income, and offer high quality of income. Although rare situations emerge (particularly during broad economic pullbacks) when you can achieve all three in a singular investment, each investment tends to tilt towards one of three over the others.

Today, I wanted to discuss the income investing strategy of choosing a high income producing asset first, reinvesting the cash produced for a period of time (such as five years), and then switching to a "de-risking" or "growth maximization" approach in which case you take the cash generated and put it in companies that either possess greater growth profiles, higher earnings quality, or better valuations.

To show you what the execution of this strategy would look like, let's take a look at Linn Energy (LINE) (LNCO).

As you can see, the reinvestment of Linn Energy's distributions on a $10,000 investment from the beginning of 2009 through part of 2014 has resulted in a share count increase from 668 total to over 1,069 shares outstanding.

Adding over 50% to your share count in five years is a nice way to boost your household income in a way that would not be apparent by looking at the distribution schedule alone. If you were to never reinvest your Linn payouts after making your initial investment, your annual income would only increase by 15% over the 2009 through 2014 stretch. Sure, it's nice to see 668 shares increase from paying out $1,683 to $1,937, but it's not significantly changing the income production from that initial $10,000 investment.

Things get more interesting when you combine that 15% growth in income with reinvest during the first five years in which you have 1,069 shares working for you to generate $3,099 in annual income. The reinvestment of cash from a cash cow energy company puts kerosene on the income growth flame, in this case permitting you to achieve a yield-on-cost of over 30% within five years of your investment. Do that a handful of times in your life, and you'll be set.

Why then, would someone stop continually reinvesting after seeing such rapid increases in yield-on-cost each year?

Well, the company carries $9.4 billion in debt, is currently paying half-a-billion dollars in interest expenses alone, and is constantly issuing new shares for acquisitions and general capital raising purposes to propel its future growth prospects (e.g., Linn had 114 million units outstanding in 2008, and now has 331 million units). Even though the payout remained static in 2009, the owners of the company had to see cash flow per unit decline from $8.99 per unit in 2008 to $3.31 per unit in 2009, and earnings per unit decrease from $7.23 in 2008 to $1.73 in 2009.

As part of prudent risk management, it can be fair to appreciate Linn's large payout while also wondering whether it could survive three repeats of 2009 in a row, and thus limit your exposure to the energy firm by taking your cash distributions and reinvesting them for a couple years to get your yield-on-cost up to a high level, and then take those distributions and perpetually reallocate them to firms with better growth profiles, better valuations, and/or higher earnings quality.

A strategy like this is as much about style as substance. Someone who begins a portfolio with the likes of Nestle (OTCPK:NSRGY) and Colgate-Palmolive (NYSE:CL) have to deal with the drawback of low initial dividend yields; it can take years and years of contributions before the dividend income amounts to something meaningful. If you choose to add high income-producing assets like Linn Energy first, the advantage is that a couple years of reinvestment on a relatively modest investment can get the yield-on-cost of your invested capital up to a high level, which then can be perpetually deployed into higher-quality names as part of a strategy to increase the quality of your portfolio's holdings. A strategy like this works best for those who care about creating a high-income infrastructure that serves as a platform for always having cash come your way to make new investment decisions. It's about pursuing high income while performing a balancing act to dull the adverse effects that can show up when you flirt with yield-chasing.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.