Defensive Dividend Portfolio Picks For 2012 (Part 4: MLPs)

by: Parsimony Investment Research

Over the course of the next several articles we will highlight our Defensive Dividend Portfolio picks for 2012. Each article will focus on a specific low-beta, defensive sector:

  1. Utilities
  2. Healthcare
  3. Consumer Staples
  4. MLPs
  5. Mortgages REITs

This article focuses specifically on the MLP sector.

Macro View

The U.S. economy continues to have significant headwinds (e.g., high unemployment, European credit contagion, weak housing market, high debt levels, etc.) and the current "relief rally" is likely to be short-lived.

The global economy is being weighed down by a debt problem that took over two decades to create. Given the significant build-up in peace time debt, we believe that the debt problem will take years to sort out, providing significant uncertainty and market volatility. The leverage that has been built up in the system will not unwind for years to come.

Source: Citigroup

Our central belief is that in a low interest-rate world, retirees and other income investors are experiencing dwindling incomes from their risk-free assets (e.g. government bonds and cash equivalents). With ultra easy monetary policy the Federal Reserve will continue to pick the pockets of savers by keeping rates low. We do not foresee interest rates at the short end of the curve rising any time soon as the debt burdens of sovereign governments as well as consumers are simply too high.

Investors Need to Focus on Stable Income Streams in 2012

As central banks drive down short-term rates to deal with high debt levels and low growth rates, investors have been flocking to dividend stocks in search of yield.

That said, any pullback in the market should be an opportunity to add to your low-beta dividend stock positions.

In the current market environment, it is important for income investors to choose their dividend stocks wisely as they are putting new money to work. As volatility increases (especially downside volatility), income investors may want to add some low beta stocks to their holdings to help dampen portfolio volatility. In general, companies with low betas will tend to be less volatile than the general market.

With a diversified portfolio of high-quality dividend paying stocks (like the ones on the list below), retirees can generate a stable income stream that will perform well in bull or bear markets.

Defensive Dividend Portfolio: Part 4 - MLPs

The Alerian Master Limited Partnerships ("MLP") Index has been on fire recently and is up over 20% since early October. While the index is technically overbought right now, we think that the strong trend in MLPs will continue into 2012 and we would be a buyer on any meaningful pullback.

Investors should take advantage of any pullbacks in the market to add to their positions in the sector. We currently like the large cap diversified MLPs the best including: Enbridge Energy Partners (NYSE:EEP), Energy Transfer Partners (NYSE:ETP), Enterprise Products Partners (NYSE:EPD), Kinder Morgan Energy Partners (NYSE:KMP), Oneok Partners (OKS), Plains All American Pipeline (NYSE:PAA), and Williams Partners (NYSE:WPZ).

While this is not an exhaustive list of high-quality consumer staples stocks, this sample portfolio would yield 5.5% with an average beta of 0.53.

MLP Overview

MLPs generally offer stable yields that are typically higher than those of common stocks. In addition, MLP returns have traditionally had low correlations with stocks and bonds, making them good portfolio diversification assets (especially in times of economic uncertainty).

As highlighted in Standard & Poor's Guide to MLPs, MLPs offer investors three distinct positive characteristics:

  1. Tax Treatment - Since MLPs are structured as partnerships they do not pay corporate income taxes. Taxes are only paid when distributions are received, thus avoiding the double taxation faced by investors in corporations.
  2. Consistent Distributions - MLPs face stringent provisions including the requirement to pay minimum quarterly distributions to limited partners, by contract. Thus, the distributions of MLPs are very predictable.
  3. Energy Infrastructure - The majority of MLPs operate in the energy sector, particularly in energy infrastructure industries such as pipelines, which provide stable income streams. The performance of companies in the energy infrastructure industry is not highly correlated with the price of oil and other types of energy, but rather with the demand for energy. The demand for energy is far less volatile than commodity energy prices and generally increases steadily over time, resulting in steady, predictable cash flows for companies in these industries.

Disclosure: I am long KMP, PAA.