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.

*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.