I was in business school when I learned the most profound financial lesson of my life. However, that lesson didn't come from a textbook, but from my brokerage account statement. I'd just received my first-ever dividend payment from a stock I had purchased. It was at that moment that I became hooked on income stocks and the passive income those stocks provided.
A personal favorite is born and then reborn
My favorite income stocks are those that pay fatter dividends, and I've found some of the fattest hiding out in the energy sector. A longtime favorite of mine is LINN Energy LLC (NASDAQOTH:LINEQ), which was a little gem I picked up shortly after it went public. Over time, I've added to my position as my portfolio has grown because I really like the generous income stream from the company's oil and gas wells.
However, one thing I don't like about LINN is the fact that, because it's an MLP, I've had to spend a little more effort at tax time filing extra paperwork, which I guess is my labor for all the income it sends my way each year. That paperwork and tax structure also meant that I couldn't buy it in my IRA account at the time because it had rules against owning MLPs.
So, I was particularly excited when LINN Energy decided to offer investors a less-paperwork-intense, and IRA-friendly, option by creating LinnCo LLC (UNKNOWN:LNCO.DL) as a vehicle to own units of LINN Energy. Because of these reasons, LinnCo has become a favorite income holding for me, and one that I was happy to double down on during the recent sell-off in the stock.
Why I should actually hate LinnCo
If I were looking for capital gains, I'd probably hate LinnCo right now. The company's stock price has been going in the wrong direction for a few years.
I'm not after capital gains from LinnCo right now. I'm looking for income that I can use for other purposes, which, in my case, is used to buy growth stocks. However, I actually like it when income stocks sell-off because, as the stock price goes down, the dividend yield goes up. So, if I buy more of an income stock after the price has dropped, I can lock in a higher long-term income stream for less money than the last time I bought shares. We can see this inverse correlation in the following chart.
Buying when a stock's price is down is all very Warren Buffett-like if you ask me. He has said countless times that he likes to buy when a stock goes down, and to be greedy when others are fearful. However, Buffett isn't stupid enough to buy just because a stock has gone down knowing that some stocks go down for a reason. And while there are legitimate reasons why LinnCo's stock is being sold off, I think investors are really overreacting.
What I see that I think others are missing
The big worry among investors is that LINN Energy will cut its generous income stream. Given that LINN Energy's income is produced by oil and gas wells, the slump in oil prices is definitely a cause for concern. However, LINN Energy is very well-insulated against the plunge in oil, as it hedges its exposure to the volatility of commodity prices by locking in the future sales of a bulk of its production a few years into the future. We see this in the following chart, which shows that nearly all of the company's cash flow is locked in for the next two years.
This slide gives me a lot of confidence that LINN Energy's cash flow is much more solid than the sell-off in the company's shares would seem to indicate. It's why I have no problem doubling down on LinnCo's stock -- because it's just so rare to find a company that has 90% of its cash flow protected for the next two years.
This doesn't mean the company won't have to ax its distribution if oil prices remain weak. Obviously, if only 90% of its cash flow is protected, then something has to give for the other 10% if prices remain low. That's a risk that energy investors simply have to live with. However, the odds of a big cut occurring are less likely than investors are pricing into the stock because, as much as investors worry about its debt, LINN Energy has years before that would ever be a problem. Further, it has plenty of options to fix the situation.
Not only that, but the current turmoil in the market offers new opportunities. The company could take advantage of the turmoil to buy back its cheap units to reduce its future distribution requirement. It could also take advantage of the fall in oil prices to buy oil assets now that the price of assets are beginning to fall. Add it all up, and LINN has countless levers it can pull to continue paying a generous distribution, even if its generosity lessens a little bit.
I took advantage of the sell-off in LinnCo to add to my position because I am not overallocated, and I can stomach the volatility while staying unafraid of a dividend cut. I also left myself some room to add even more if the sell-off continues.
While there's a growing risk that the dividend will be reduced, that's a risk that no income stock is without, especially one that pays out as much as LINN does. I'm simply of the opinion that LINN is better insulated to handle the current storm than investors give it credit for, so I have no problem being a little greedy while others are fearful.
Matt DiLallo owns shares of Linn Co, LLC and Linn Energy, LLC. Matt DiLallo has the following options: short January 2015 $20 puts on Linn Co, LLC. 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.