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Energy master limited partnerships have been on a tear, and it's all the more reason you should be very choosy before buying newcomers and old timers, says Peter Staas of Energy and Income Advisor.

Gregg Early: I am here with Peter Staas, managing editor of Capitalist Times.

Peter, when I look at the marketplace, even though stocks have gone up and the third quarter was supposedly a great quarter, people are still kind of hunkered down looking for income. Where is the best place to find the big yields these days that isn’t overbought? Where is it overlooked?

Peter Staas: Investors are definitely on the hunt for yield. Especially with where interest rates are right now, there isn’t much out there.

One of the traditional high-yield sectors that we like are energy-focused master limited partnerships (MLPs). They have become increasingly popular among investors—the secret is out. The Alerian MLP Index is yielding about 5.7%, which is down considerably from the summer of 2011 and earlier this summer.

You have 47 different funds that focus on the space now, close to 30 of which have launched within the past two years or so. It’s definitely a lot of money moving into this space.

One mistake that we see investors making who are looking for yield is that they are looking for the highest-yielding stuff. In the MLP space, there is a reputation that it’s a lot of toll road-type, consistent cash flow generators. A lot of this higher yield stuff does have risk; you need to understand what you are investing in.

Gregg Early: So you are talking about more of sustainability of the dividend or the investment, more than just looking at the number.

Peter Staas: That’s true. Sustainability...and what I think is key at this point is distribution growth, because a lot of the more popular names have been bid up considerably.

I look at a name, for example, like Western Gas Partners (WES). They have a clear pipeline of drop-down transactions from their general partner which is going to fuel distribution growth. They have also got an impressive lineup of expansion projects underway. It’s yielding less than 5%, but when you factor in that distribution growth, which is going to be occurring at an above-average rate, we would prefer to own that rather than a higher-yielding name.

For example, a name that a lot of people like is Navios Maritime Partners (NMM). We think that is one of the better higher-risk names to put your money in...but we would only nibble on it.

There is a lot of risk regarding whether the company will have access to capital markets. They are in the dry bulk shipping area. Day rates there are depressed. They have got some contracts rolling off. There are questions about distribution sustainability.

So yes, there is a high yield. Is it going to grow the distributions? Probably not. We prefer a name like Western Gas Partners.

Traditionally, when the MLP sector gets bid up, there has been an opportunity for people to find some value in recent IPOs. There is a huge pipeline of MLP IPOs, potential ones—it’s up around 16 or 17. We're not really keen on a lot of these names. We are seeing a bubble forming there in terms of IPOs, where there are a lot of names that are going to offer a high yield potentially, but again we don’t see much opportunity for distribution growth.

Gregg Early: I would assume, as with all income investments, the fact that you want to be in these stocks for a while. You don’t want to keep jumping in and out. You want to hang onto them...so you need names and companies that are going to be able to sustain their growth and kick off nice dividends to the investor.

Peter Staas: Exactly! That’s exactly what we are looking for. Traditionally with the IPOs—especially the ones in the MLP space—their prospectus will tell you what their minimum expected distribution will be based on projections. Obviously, you need to pay very close attention to that, and question the assumptions that underlie it.

They would pay maybe a prorated distribution for their first quarter. A lot of times, the Web sites like Google Finance and that sort of thing, brokerage Web sites, would incorrectly calculate the yield (too low). Which really gave you an opportunity to get in, because once they start to calculate that yield appropriately to reflect the actual distribution, the stocks tend to take off a bit.

Again, we are not too keen on the latest batch of MLP IPOs that are coming out. What we do see as an opportunity is companies that are spinning off assets as MLPs.

A company that we like, regardless of whether or not it makes this move, is Gas Log (GLOG). They own a fleet of LNG (liquified natural gas) carrying vessels. That is a market that we really like. It's one of the tightest in terms of supply/demand shipping market currently.

Gas Log has a solid slate of vessels that are booked under long-term contracts and then they also have a number of new ships that they are going to be receiving in the coming two years that will enable them to take advantage of the tight rate market that currently exists.

Gas Log is talking about spinning off some of those vessels that are booked under long-term contracts as an MLP. We think that would really unlock a lot of value for the company. Again, it’s a company we already like, regardless of whether or not they make that move.

We've seen Golar LNG Partners (GMLP) IPO last year to a great deal of fanfare, and the stock has done well. There is a bit of a scarcity premium around companies that are involved in the LNG shipping market.

Another one is Teekay LNG Partners (TGP), which offers a really nice yield above 7%. The reason that yield is so high is that there's really no contract risk per se; they don’t have much exposure to the near-term bull market in contract prices, which is why it's up around 7.5%.

At this point, to put it in perspective, GLOG is currently yielding around 2% to 2.5%.We think that with the MLP spinoff, that could lead to some substantial price appreciation, and the stock also could have a very nice distribution yield.

Source: Buying MLPs For The Right Reasons