These Stocks Could Lose Your Money

We're all dead in the long run, but some exit stage left sooner. That doubles for companies. I'd rather find companies whose business models, and managers, position themselves to weather the inevitable storm.

Some business models seem built to fail, destined to nuke shareholder returns along the way. And when times turn tough, exploration and production (E&P) companies structured as master limited partnerships (MLPs) fit that bill, sadly.

Where opportunity meets failure
An E&P's modus operandi is to pull oil and natural gas from the ground. It's dirty business -- capital intensive for the high fixed costs of running rigs, cyclical because oil and natural gas prices constantly zigzag, and usually high leverage (i.e., lots of debt) because it takes money to make it in the drilling game.

As for MLPs, they pay all of their earnings to shareholders as dividends, in exchange for a waiver on taxes. The structure affords lower costs of capital most of the time and meaty dividends for shareholders. But it's no free lunch. While ordinary corporations are able to finance their operations internally (or at least partially) by retaining earnings, MLPs typically do not. They raise money for day-to-day operations by issuing debt, common stock, or sometimes preferred stock.

The incongruence should be obvious. Take a cyclical, capital-intensive business, then wedge it into a structure that's totally beholden to the capital markets. You've concocted a recipe for value annihilation.

A tale of marginal returns
When markets are flush, or even average, this model works just fine. Investors are perfectly willing to buy bonds at a reasonable interest rate, or pick up common stock in a secondary offering. MLP-styled E&Ps raise money and chug along.

But markets aren't always friendly, as 2008 and 2009 made obvious. When commodity prices turn south, and profits are accordingly scant, E&Ps need capital. Simultaneously, share prices turn down, and investors demand higher interest rates on bonds. That makes capital most expensive when MLP-styled E&Ps are most likely to need it.

Ordinary C-corporation peers -- companies like Devon Energy (NYSE: DVN  ) , Southwestern Energy (NYSE: SWN  ) , Anadarko Petroleum (NYSE: APC  ) , and even the very levered Chesapeake Energy (NYSE: CHK  ) -- can retain earnings to fund drilling budgets, maintenance expenditures, or to pull through lean periods. And if they issue debt, capital comes a little cheaper because they can retain earnings.

But MLPs -- particularly the most undercapitalized -- aren't so fortunate. In tough times, they may have no choice but to issue debt, or shares, at sometimes prohibitively expensive rates. It's that, or sometimes risk failing altogether. Don't believe me? Take a look at these share offerings, in the depths of the credit crisis.

Company

Date

Price at Issue

52-Week Low

% of Share Base, at Year's End

Current Share Price

Linn Energy (Nasdaq: LINE  )

5/13/09

$16.25

$12.90

5.3%

$30.01

Penn West Energy Trust* (NYSE: PWE  )

2/5/09

$11.44

$6.77

4.3%

$19.95

 EV Energy Partners (Nasdaq: EVEP  )

6/16/09

$20.40

$12.50

18.4%

$34.00

*Penn West is a Canadian Royalty Trust (canroy), the Canadian cousin to MLPs. It's shedding its Canroy status soon, and converting to a traditional C-corporation.

I know what you're thinking: "The credit crisis was a once-in-a-whatever event." But that's exactly the point. These businesses aren't trying to hurt shareholders, nor are their managers incompetent. Their business model is simply ill-equipped to withstand the inevitable shocks to the market.

When the market shuns risky assets, the MLP E&P is more or less forced to take the market's terms if it needs money. Those terms typically aren't generous, which limits shareholder returns. Sure, C-corporations sometimes end up in similar straits, but that misses the point. They've the option to retain earnings, whereas MLPs cannot. And that's not good for business.

I'd short these stocks ...
… if I could. Well, I'd short a basket of them, right as market commentators started crowing about $200 oil and $15 natural gas again. In time, that gambit might pay off.

But I wouldn't short them in the first place, because short-sellers have to pay dividends on the securities they've sold short. So while I think companies of this variety will face hard times when the market throws its back out again, a short could get awfully pricey -- between dividends and the cost of borrowing shares. Instead, it makes sense to avoid them with religious zeal.

Looking for businesses you can safely short, and on a more timely basis, without the risk of getting dinged by dividends? My Foolish colleague John Del Vecchio, CFA, a leading forensic accountant, offers a list of warning signs to look for in this free special report -- "5 Red Flags -- How to Find the Big Short." Simply enter your email in the box below, and I'll send you the report. It's free.

Michael Olsen owns shares of Chesapeake Energy. Chesapeake Energy is a Motley Fool Inside Value pick. The Fool owns shares of Chesapeake Energy and Devon Energy. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (50)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 17, 2010, at 5:34 PM, steveelcpo wrote:

    Ok, so I see your point about retaining earnings to get them through the inevitable down cycles of a very cyclical industry. But, your examples make the case for buying these. If my math is correct, if you'd bought 100 shares of LINE, PWE, and EVEP at the issue price, held them through the low and sold them now, you'd be sitting on a gain of $3587 on an original investment of $4809. Looks like about a 75% return PLUS their distributions, which are currently between 8.5 and 9%. If you had made this recommendation when those shares were issued, you'd be a hero, and most everyone on this board would send you Christmas cards and buy you a beer! You point about going into any investment with your eyes open and doing a fair evaluation of the risks is well taken.

  • Report this Comment On August 17, 2010, at 6:12 PM, MAcDScientist wrote:

    OK, I must be missing something here. If I bought these companies at issue and held to now, I would have 84%, 74%, and 66% gains respectively in around 16 months. Plus, I would have received the dividends on top of that. It would appear to me that as long as the company can weather the economic storms (as these seem to have), the real risk is panic selling in a downturn. One needs to stay current and make sure the company can cover it's debt and still pay it's dividends, but that is true with any company, not just MLPs. I suspect by the stock prices, these companies are not in danger of lowering dividend payouts.

  • Report this Comment On August 17, 2010, at 6:15 PM, mikecart1 wrote:

    How do you make fun of LINE and PWE? They offer great dividends and their stocks have soared!

  • Report this Comment On August 17, 2010, at 7:20 PM, andcuriouser wrote:

    I have owned LINE for years, through up and down. The dividends are substantial and only go up as far as I can remember although not as often as I would like. I believe their FCF could have allowed a much more substantial distribution [ok, return of capital to be technical]. So they do find ways of retaining earnings or FCF really. I have bought more in past years and I am up very substantially, independent of dividends. If I had bought one of Wall Street's perennial darlings, like J&J, I would have puny dividends and little capital gain. I found this article unhelpful in light of my experience.

  • Report this Comment On August 17, 2010, at 7:59 PM, indylush wrote:

    If you truly believe shorting these stocks would be a good idea except for the issues that you brought up, wouldn't buying puts at, say, $25, $15 and $30, respectively, be a better idea and give you the advantages of not paying premiums, etc etc... and still yield you a big return if they really do tank, as you seem to think they will?

  • Report this Comment On August 18, 2010, at 11:38 AM, TMFAgewone wrote:

    @ steveelcpo, MAcDScientist: You're right that these stocks are up, but that doesn't change the underlying point. To EVEP, LINE, and PWE's credit, they've managed their liquidity/capital positions fairly well, with some exceptions. But what remains is true: If credit markets turn sour at an inopportune time, these companies can get squeezed in a horrible way (issuing debt at high rates, or equity at low prices). In a best-case, that will reduce value that accrues to shareholders. Bad case: these companies may be forced to sell assets at fire-sale prices. Worst case: if they're really leveraged, could be forced out of business.

    I'm not saying this will happen, but it can. That risk is magnified for these types of companies.

  • Report this Comment On August 18, 2010, at 12:15 PM, TMFAgewone wrote:

    @ indylush: First, let me say that I don't think these stocks are poised to tank. I think their business models leave them disadvantaged compared to their peers, which incrementally increases the chances of them tanking.

    On puts: Theoretically, the idea works. The trouble with this sort of gambit is that there's not an immediate catalyst, and puts have limited shelf life. Per my earlier point, these business' failure isn't imminent. But they will face tough times if/when the market comes on hard times. I don't know whether that's tomorrow, or 2 years from now, which makes buying puts a little harder to do with confidence.

  • Report this Comment On August 18, 2010, at 6:38 PM, jegbrown wrote:

    What a sophomoric article! You did not mention anything about the hedging of their operations in the forward markets to spread the risk. Most mlps have done very well in the last couple of years in spite of poor pricing in several NG areas. They have, by proper hedging, done quite well compared to the over-all stock market. You also neglected to discuss the favorable tax aspects of mlps.

    I sleep better every night knowing that most of my holdings are paying a very good distribution return with modest increases every year. This is in direct contrast to most stocks that pay minimal, if any, dividends and you have to hope for price appreciation in a very capricious market!

  • Report this Comment On August 19, 2010, at 10:57 AM, pondee619 wrote:

    "First, let me say that I don't think these stocks are poised to tank."

    "I'd short these stocks ... if I could."

    "But I wouldn't short them in the first place"

    "they will face tough times if/when the market comes on hard times" DUH

    So, let me get this straight: You are not saying that these stocks are poised to tank, but you would short them if you could, but you would not short them in the first place and if the market comes on hard times thesse issues will face tough times. I guess we have all bases covered. Thanks for taking a stand.

  • Report this Comment On August 19, 2010, at 1:40 PM, kramsigenak wrote:

    @pondee619, good point!

    Author: This type of energy investment has a lot less risk that most investments out there (of any sort). I've been getting over 10% distribution as the stock has climbed from 24 to 29. The distribution is WELL hedged into the future, so I collect a "salary" (fully tax deferred). That provides for incremental compounding gains... aside from the capital gain! This formula has been the Least risky of my portfolio. It's bad business in my opinion to scare folks off this extremely well managed company that has the Very likely promise of providing a High rate of return (via distribution) hedged well into the future. It's exactly the kind of investment to own as the market is so volatile. Solid 10% returns (not even counting stock upside)?? I'll take it every quarter, and a-thank you very much Linn Energy.

  • Report this Comment On August 19, 2010, at 3:19 PM, TMFAgewone wrote:

    @ pondee619 and kramsigenak: Fair comments, but I think we're talking to two different points. They've hedged their selling prices for natural gas, but that does not protect them from the risk that they'll have to raise money at very expensive rates.

    They still cannot retain earnings, which means they cannot internally finance their operations. So their options are still limited if/when they find themselves needing money, because they rely upon debt and/or equity markets to fund their drilling operations. Hedged or not, that doesn't change.

  • Report this Comment On August 20, 2010, at 2:21 PM, Golbguru wrote:

    Author: This is an extremely poorly written article. For all you fools out there on Motely Fool - please stop writing about MLPs if you do not understand them.

    You pick MLPs that DID survive the grand daddy of all credit crunches - not only did they survive, but have outpaced most other stocks by a more-than-handy margin.

    In your comments you say: " Per my earlier point, these business' failure isn't imminent. But they will face tough times if/when the market comes on hard times. I don't know whether that's tomorrow, or 2 years from now, which makes buying puts a little harder to do with confidence."

    Really? is that genius or what? if the market comes upon sustained tough times - which asset class has passed through such times without causing you a loss?

    Moreover, if you cannot predict that, then it is incredibly stupid to be shorting one of the best asset classes (MLPs) (from before the credit crunch to present) on some weird "what if" scenario. It's like trying to short AAPL because Steve Jobs is going to die someday - you don't know when, but you know it's a certainty.

    In addition, you do not mention anything about the following issues that are key to evaluating MLPs:

    1. Widening yields spread

    2. Price/Distributable cash flow

    3. Tax deferred status of MLPs (especially, against the prospect of increase in dividend and capital gains taxes)

    Raising equity is not a bad things at all if companies know how to use it wisely - the MLPs you mention are especially good at that.

  • Report this Comment On August 20, 2010, at 5:11 PM, TMFAgewone wrote:

    @ Golbguru: I appreciate your comment, but I'm not sure that it addresses my point. MLPs are fine -- I know and like them, and own several partnership structures myself.

    Per the article, my qualm is that these companies are very cyclical, capital intensive, and reliant on markets for sources of capital. Widening yields, price/distributable cash flow, and tax deferred status don't change that. These companies cannot retain the cash they generate, leaving them subject to the market's whims.

    I agree raising equity is not bad, but that's a matter of opportunity cost--if the return on the project exceeds the cost of issuing equity and/or debt. These companies, by virtue of their structure, sometimes cannot choose when to issue equity. If debt's coming due, or they need money, they do it. And so, it's no longer just an opportunity cost analysis.

    Thanks for your comments.

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