Now that we have covered the basic premises of the Protected Principal Retirement Strategy and examined some thoughts on asset allocation, I wish to focus on individual asset classes, beginning with the Master Limited Partnerships.
Before beginning, I suggest if you haven't already done so, that you review Part I (here), Part II (here) and Part III (here), as there is information in this Part IV article that is based upon previous articles.
Two clarifications need to be made relative to statements made in prior articles, since I have received several comments on them. First of all, when I mentioned that the person referred to in my example with a $300K portfolio would require a 12.7% yield, a person with a $400K portfolio would require a 9.5% yield, and a person with a $500K portfolio would require a 7.6% yield, I was not implying that these percentages equated to a required minimum distribution [RMD] from principal. These are the amounts the portfolios would have to generate annually in dividends and distributions. The Protected Principal Retirement Strategy is predicated on withdrawing dividends and distributions, not principal.
Secondly, I mentioned that the required yield equated to one's risk tolerance. What I am saying here is that if an individual requires a 9.5% annual yield on their portfolio, their risk tolerance level would be whatever it takes to attain the 9.5% yield.
I can say unequivocally that MLPs are my favorite asset class. My portfolio is overweight with them, and I only wish I had discovered them earlier than I did. The months of January, April, July and October are probably the favorite months for holders of MLPs. Those are the months in which quarterly distributions are announced. This month it appears that distribution increases across the [MLP] spectrum are as good as they have been in quite a few quarters. So it is a good time to make decisions about future purchases, or additions to existing positions.
I am not going to spend time reviewing the basics of master limited partnerships. There are many, many articles on SA dedicated to this topic. Suffice it to say that those that are limited partnerships issue K-1s, and those that operate as LLCs may issue a 1099. A lot has been said about unrelated business taxable income [UBTI]. I can say personally that it has never been an issue for me, and probably will not be one for you.
For those wishing to get an education about master limited partnerships, I suggest the National Association Of Publicly Traded Partnerships (NAPTP.org). There are others equally good. A few websites that I use for information include: MLP Hindsight (mlpguy.com), Dividend Detective (dividenddetective.com), and The Yield Hunter (dividendyieldhunter.com). I do not like message boards; however Investor Village has an [MLP] board that has several very astute energy investors commenting. There are, of course many others, but these are just of few of those I consider to be most informative.
Energy master limited partnerships can be subdivided into three general categories: upstream (exploration and production), midstream (pipelines and infrastructure), and downstream/other (storage, transportation, gathering/processing, general partners, etc.).
In my opinion, the midstream MLPs are the most stable, since they are least subject to price fluctuations in the underlying commodities. I would rank the downstream MLPs as next most stable, and the upstream MLPs as least stable since their price movements are very sensitive to that of the underlying commodities.
There are a number of ways to evaluate MLPs, the most important of which are: distributable cash flow [DCF], the distribution coverage ratio [DCR], and the five-year compound annual growth rate [CAGR]. These are defined as follows:
Distributable Cash Flow = Net Income + Depletion, Depreciation and Amortization + Non-Cash Items - Maintenance Capital Expenditures. Each quarter I compare [DCF] with that of the prior quarter and that of the same quarter from the previous year. Look for increases in both places.
Distribution Coverage Ratio = Distributable Cash Flow/Actual Cash Distribution. The [DCR] should be at least 1.0, and preferably 1.2 or higher.
Compound annual growth rate, the forecast growth rate, usually viewed over the future five year period. For MLPs, the [CAGR] should be at least 5 percent per year, preferably higher.
One additional evaluation metric applying to the upstream MLPs are their hedged pricing on commodity production.
A good source for evaluative information and metrics are the conference call minutes published by SA.
Quarterly earnings are not nearly as important as for regular stocks since the MLPs are intended as a tax shelter. MLPs are no different from other stocks in one's portfolio - you must stay on top of them.
Normally, a few times a year most MLPs will have secondary stock offerings; this is how they generate funds for capital projects, or for debt repayment. This might temporarily cause dilution, but they seem to recover quickly. I normally use secondary offerings as a means to acquire additional stock at a lower price.
Another trick to use to initiate, or add to an [MLP] position is the "stink bid". Those of you whom follow the MLPs closely have probably noted that from time to time the share price will, for no apparent reason tank noticeably. A stink bid is a limit order to buy at a significantly lower price than that which the stock currently trades. I have my favorite MLPs, and I usually have a good until cancelled stink bid entered at a price that is 10 to 15 percent below the current price. You will be surprised at how many times these will get filled (flash crashes). Just be sure to have cash in the account to cover executions.
If we assume a total allocation of 7.5 percent of our portfolio that would suggest holding two, and possibly three upstream MLPs. A lot has been written about oil, natural gas and liquids prices, and where they might head in the future, as well as the hottest locations for domestic production. The best of the upstream plays have hedged production for the coming three or so years, and I think these are the places to look. From my perspective, I have owned Breitburn Energy Partners (BBEP) and Vanguard Natural Resources (VNR) for quite some time. Of the two, VNR is the most well-hedged. I very much like Linn Energy (LINE), EV Energy Partners (EVEP) and QR Energy (QRE) for much of the same reasons. If the price of LINE were to drop to the point where the yield approached 8.5 percen,t I would be a buyer.
As far as distribution announcements this month, BBEP has not announced as yet (but has increased distributions for eight consecutive quarters), and at its present price yields right at 10 percent. VNR announced a quarterly distribution of $.60, a 1.2 percent increase over the prior quarter. This is the seventh consecutive quarterly distribution increase, and at the current price (July 24) VNR yields 8.6 percent.
LINE should be announcing in the next day or so, and expectations are for a slight increase above last quarter's distribution of $.725. The present yield for LINE is 7.3 percent. EVEP will also be announcing in the next few days and has increased its distribution ever quarter since its inception (21 quarters). EVEP has a current yield of 5.8 percent but might offer the greatest short-term appreciation potential. Finally QRE, the newbie in the upstream space. QRE began trading in February 2011, does not have the track record of the others discussed herein, but has increased its distribution by perhaps the highest percentage of all. For the current quarter, QRE will pay $.4875 and has a yield of 10.5 percent.
As an example, if one was to purchase 100 shares of BBEP, VNR and LINE at current prices, the total cost outlay (exclusive of commissions) would be $8582. The annual distributions from all three (assuming this quarter's distributions did not increase over the next three quarters) would total $712 for an overall yield of 8.3 percent.
I am using 100 shares as an example only; if you opt to adhere to this strategy or a variant you can adjust the number of shares accordingly.
The midstream space has shown a fairly consistent level of price appreciation over the years, and for that reason many of the largest ones: Enterprise Products Partners (EPD), Kinder Morgan Energy Partners (KMP), Plains All American (PAA) etc., no longer yield what they did several years ago. I have a 25 percent allocation to this sector, primarily because I have owned these for the longest period of time. For example, several years ago I owned Teppco Partners, which was acquired by EPD. I gained a good position in EPD as a result, and have re-invested distributions every quarter (with this month's distribution announcement, EPD has 32 consecutive quarterly increases). As a result, my average per share price is just above $20 a share, and with the present distribution rate of $2.54, the yield on my cost is 12.7 percent. I wish I could report this for all of my MLPs. In addition to EPD, I presently have a long position in Regency Energy Partners (RGP).
I believe that there are several midstream MLPs that offer a substantial distribution protected by coverage ratios in excess of 1.0 that will garner a decent yield for our hypothetical portfolio. RGP, Crosstex Energyp LP (XTEX), ETP, and El Paso Pipeline Partners (EPB) all come to mind. If one is willing to accept a lower yield with perhaps a higher level of total return, throw in EPD, PAA and Genesis Energy (GEL).
Let's use RGP, XTEX, ETP and EPB as four portfolio examples. RGP should announce later this week. After a three year hiatus where distributions remained constant at $.445 a quarter, RGP has once again begun to provide shareholders with quarterly increases. At its present distribution level of $.46, and at the current price, RGP has a yield of 7.7 percent. XTEX announced a quarterly distribution of $.33, the same as the previous quarter. At the current price, XTEX yields 8.0 percent. EPB (which is being acquired by Kinder Morgan) has announced a distribution of $.55 (an increase of 7.8 percent over the prior quarter); we note that they have increased distributions each quarter (18 quarters) since inception in 2008. At the current price, EPB yields 6.3 percent. Finally ETP, which has been somewhat of a black sheep in the midstream sector (having kept their distribution constant for 14 straight quarters) is paying $.894 ($3.58 a year). From what I have read about the midstream space, many [MLP] pundits anticipate increased distributions, beginning in this, or next quarter. At the current price, ETP yields a little above 8.0 percent.
Again, let's assume we purchase 100 shares of each of these four midstream MLPs. The total cost (excluding commissions) would be $12012, and annual distributions would come to $888 for an overall yield of 7.4 percent.
There exist a large number of MLPs that fall into this grouping. In my opinion, some of the best include: Global Partners (GLP), Calument Specialty Products Partners (CLMT), Transmontaigne Partners (TLP), Eagle Rock Energy Partners (EROC) and Penn Virginia Resources Partners (PVR) (I classify PVR as other, since they are predominantly a natural gas pipeline and coal company). A few that I consider more speculative are compressco Partners (GSJK) and Exterran Parnters (EXLP). I currently am long several in this space, including: TLP, GSJK, CLMP, GLP, and EROC.
Since our allocation to these is 7.5 percent of our hypothetical portfolio, let's examine CLMT, EROC and PVR as candidates. CLMT recently announced an increased distribution of $.59 for this quarter, an increase of 5.4 percent above last quarter. At the current price, CLMT yields 9.4 percent. CLMT happens to be my favorite in the downstream space, and I am sick that I did not add to it in late June when it was in the $22s.
EROC is a gathering/processing [MLP] which also transports, trades and fractionates natural gas and natural gas liquids. I believe that natural gas and liquids prices will ramp up again by winter, and this, coupled with the company's announcement of several months ago that they anticipate the distribution reaching $1.00 by end of 2012, holds my interest. EROC announced a $.22 distribution and stated that they might not reach the $1.00 level by end of 2012. At the current price EROC yields 9.4 percent.
I have always personally liked PVR, despite their position in coal and natural gas. I have owned the stock in the past, and am always looking for a new entry point. They have done well over the years and continue to increase distributions. The present annual distribution is $2.08, and at the current closing price, the yield is 8.3 percent. I would look to buy PVR below $23, if possible.
Assuming the purchase of 100 shares of each, the total invested capital (exclusive of dividends) would be $5968. Annual distributions would total $532, for a yield of 8.9 percent (higher, if EROC increases their distribution).
I would be remiss if I did not include one of what I consider to be the strongest stocks in the energy sector - Seadrill, which is a Norwegian company specializing in deepwater and harsh environment drilling. While not an MLP, SDRL has a fleet of close to 60 offshore drilling rigs. The stock has only been listed since June 2010, but has established an enviable record of dividend payments. Their dividend payment has grown from $.60 per quarter to last quarters payment of $.97. Two of these payments included special dividends. In early July of this year SDRL filed a registration statement with the SEC for Seadrill LLC. In addition SDRL has spun off NATDF; a harsh weather driller, that intends to list on a U.S. exchange this Fall. It presently sells for around $1.70 a share and pays a quarterly dividend of $.045.
Disclaimer: It is not my intention to recommend purchase of any of the stocks mentioned in this article. I am not a registered adviser, nor is it my intention to coerce anyone into purchasing a stock. These articles represent a strategy that I use and my intention is solely to share ideas and concepts.