Master limited partnerships (MLPs) are a favorite of income investors for their high yields. But as the recent examples of Boardwalk Pipeline Partners and Eagle Rock Energy Partners illustrate -- with 81% and 30% distribution cuts, respectively -- high yield alone isn't sufficient. Rather a combination of yield, security, and growth is necessary to create long-term outperformance.
As a general rule of thumb, retirees are advised to sell 4% of their portfolios to live off of during retirement. To prevent the need for selling, a yield of 4% or greater is advisable.
The average inflation rate from 2000 to 2009 was 2.56%. It was 2.29% from 2010 to 2012 and thus far in 2014 has been 1.1%. Since 1913 the average inflation rate has been 3.22%.
In general, total returns can be estimated by adding current yield and projected distribution growth rate. The stock market's historical return (1871 to 2013) has been 9% CAGR (9.2% with dividend reinvestment).
Thus, distribution growth is important for two primary reasons. First, growth of 4% or better over the long-term outpaces inflation; this is vitally important for retirees. Second, it ensures market outperformance; this is important on a risk adjusted basis.
Think of it this way: If the market has historically returned 9.2% CAGR, this means that, over a long enough period of time, investing in low-cost index funds is a very safe way of growing wealth. Individual stocks (or MLPs) are riskier than just parking your money in an index fund and you should be compensated for this risk. This brings me to another rule of thumb when investing in any distribution/dividend paying company: the rule of 12.
This rule states that the current yield and projected dividend/distribution growth rate should equal 12 or more. This maximizes the chance of outperforming the general market sufficiently to compensate for the added risk of owning individual companies. When combined with a good selection of quality investments and proper diversification, this strategy results in superior long-term wealth creation and income generation.
Plains All American is one of the poster children of consistent distribution growth: 37 out of the last 39 quarters. Over the last 10 years, its distribution has an 8.4% CAGR growth rate. This is about quadruple the rate of inflation, and the story only gets better.
In the last year, the growth rate was 9.6% with management guiding for a 10% growth rate for 2014. Given the partnership's 4.6% yield, long-term investors should do very well owning this partnership. Of course, that is only if the yield and future distribution growth are covered by future cash flows, which all indications are that they will be.
Currently, Plain All American's distribution coverage ratio is 1.28. Anything at 1.1 or above indicates a very safe distribution that can safely grow. Management is guiding for a long-term ratio of 1.1 (which includes its 10% distribution growth guidance). This indicates that management has good distribution discipline (focusing on responsible growth that is sustainable in the long term). Future cash flow growth is likely, due to the partnership's excellent track record of accretive acquisitions ($10 billion worth over last decade) and its current $1.9 billion in liquidity (to make further acquisitions or invest in expansion projects).
Energy Transfer Partners yields a higher 6.8%, a more speculative option. Between 2009 and 2012 distributions did not grow at all. But recently it raised its distribution by 2.9%, and future growth catalysts could see distribution growth increase substantially. These catalysts include natural gas export projects. The partnership recently received FERC (Federal Energy Regulatory Commission) approval for a pipeline that would export 140 million cubic feet/day of natural gas to Mexico (this represents about 10% of southern traveling gas).
One additional catalyst is the partnership's 40% stake in the Lake Charles LNG export project. This $11 billion project is being financed with 75% debt/25% equity and will offer the partnership large and steady cash flows (20-year contracts) to grow its distributions at an accelerated rate. With a current yield of 6.8% and distribution coverage ratio of 1.05 (management is guiding for 1.05 long-term coverage), distribution growth might reach 4%-5% given the future growth catalysts.
Distribution growth is one of the most important aspects to successfully investing in MLPs. As just illustrated, Plains All American is a proven winner with high yield and a strong, consistent distribution growth rate and is likely to generate long-term market outperformance.
In contrast, Energy Transfer Partners has struggled with growing its distribution, though recent investments in natural gas export capacity could act as a catalyst for future growth. Investors should consider both partnerships but keep in mind that Energy Transfer Partners is more of a speculative play on America's natural gas boom. 3 stock picks to ride America's energy bonanza
Record oil and natural gas production is revolutionizing the United States' energy position. Finding the right plays while historic amounts of capital expenditures are flooding the industry will pad your investment nest egg. For this reason, the Motley Fool is offering a look at three energy companies using a small IRS "loophole" to help line investor pockets. Learn this strategy, and the energy companies taking advantage, in our special report "The IRS Is Daring You To Make This Energy Investment." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free.
3 stock picks to ride America's energy bonanza
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.