What if I were to tell you there's a special class of investments that not only pay you a generous amount of cash to own, but that will also have Uncle Sam looking the other way when you get pad? No, its not a scheme. It's a special type of company in the energy and materials world known as master limited partnerships.
Now, you can treat these types of investments like any other and try to buy low and sell high, but with master limited partnerships that's actually one of the last things you want to do if you want to realize the real benefit of owning them. So let's look at why MLPs are unique, and how you should think about investing in this special category of stocks.
Spared from the tax man
MLPs are an attractive investment not just because they're typically high-yielding dividend stocks, but also because the cash payout to owners is tax advantaged. Unlike a dividend from the traditional C-corp, a master limited partnership passes all of its income-tax obligations to individual owners of the stock. In exchange, you as the investor pay taxes on your portion of the income at your personal income-tax bracket.
This is important because you're only taxed on net income per share, which may be less than what the company pays you in cash payouts. Also, you get to realize depreciation and amortization expenses, therefore lowering your taxable income and gains on that investment. Any cash paid to you in excess of net income is considered a return on capital and not taxed until you sell the investment. To better understand this point, let's have an example.
| Year 1: Purchase 1,000 units of an MLP at $15.00 per unit. Your basis (paid in capital): | $15,000 |
| You receive an annual distribution of $1.25. Reduction of payment in capital: | $1,250 |
| You are responsible for $0.25 per unit in taxable income, including $1.00 in net income and $0.75 in depreciation and amortization. Increase in equity value: | $250 |
| Adjusted basis (paid in capital distribution + equity value increase): | $14,000 |
| Year 2: You sell all your units at $16.00 per unit: | $16,000 |
| Total gain -- selling price minus adjusted basis price ($16,000-$14,000): | $2,000 |
| Captured benefit of depreciation and amortization ($0.75 per share): | $750 |
| Total taxable gain after appreciation and amortization (taxed at capital-gains rate): | $1,250 |
Source: Master Limited Partnership Association.
So in this example, you paid taxes on only a small portion of the distribution you received because the distribution was greater than your portion of the net income (a return on capital), and you were able to realize the benefit of depreciation and amortization on that taxable income. It isn't until you sell that you're taxed on those returns on capital gains. So an investment in a master limited partnership gives you incentive to hold on to it over long periods of time, even more so than a traditional stock.
Of course, it's not all rainbows and unicorns when it comes to these kinds of companies. Once all of your capital has been returned through distributions -- your adjusted basis goes to zero in the preceding table -- then you have to pay capital gains on those excess distributions. However, if you reinvest those distributions back into the partnership, then you're continuously replenishing your paid-in-capital. Also, since you're paying your portion of the company's taxable income, the tax form for master limited partnerships is a bit more complicated than a traditional stock, but the long-term tax benefits can be well worth the time.
But again, to realize the full potential of these benefits, you need to buy and hold these investments over a long period of time. MLPs are traditionally in industries where earnings growth is modest, so the value in these investments lies mostly in their ability to pay out generous amounts of cash to its investors on a regular basis.
Buy low. Yeah, that's about it.
Just because the value of owning a MLP comes from holding that investment over a very long time, that doesn't mean buying low and selling high is completely obsolete. As an investor, you just need to focus on the first half.
Remember, most of the companies in the MLP space are in industries where earnings growth isn't huge, and for the most part they're in cyclical businesses dealing with natural resources. So when making an investment in this space, here are some basic guidelines to follow to improve your chances at getting higher returns
1. Identify top-flight MLPs that have a history of paying an ever-increasing dividend over time.
Lot's of MLPs have been formed lately, but very few of them have gone through the trials and tribulations that companies in a cyclical market face. Similarly, several MLPs pay out a distribution that's hard to maintain. Typically, they pay out nearly all, and sometimes more than, the total cash available to be paid out after expenses. If a company were to see any decline in business, that distribution can get reduced, and typically with it goes the unit price.
Some ways companies can protect themselves from reaching this fateful moment is to insulate themselves from the cyclical nature of the commodity business through contract structures. Or they can deliberately pay a bit less out to investors than the total amount of cash available for distribution. Then, when the tough times come, they have something to fall back on.
2. Buy when the MLP yields are high.
Once those higher-quality investment targets are identified, then it comes down to buying them at attractive returns. One obvious indicator is to look at an MLP's distribution yield. When times get rough and share prices decline, distribution yields increase at almost at an inverse rate. This chart of Enterprise Products Partners' share price and distribution yield shows the relationship:
When a company's shares have been pushed down, you can receive a higher yield on your investment. So when a company's yield is at a return level you want, lock it in.
Of course, timing the market is pretty much impossible, and for some it's simply too much effort. That's OK. In many cases, great returns on master limited partnerships can simply be achieved by investing through the cycle. That means investing smaller amounts at regular intervals. While some may say it's not perfect, it's surprisingly more effective than you might think.
What a Fool believes
Buying low and selling high is one of those pieces of advice you'll hear from someone on Wall Street who wants to make a quick buck based on the daily fluctuations of the market. For the individual investor, though, the taxes and transaction fees from trying to make money like that make it close to impossible to succeed. For those of us looking to generate an income stream or build a nest egg for later, we're much more likely to get there by buying companies and holding them over the long run.
MLPs are a great vehicle for this kind of investing. They pay generous yields to investors and are tax-advantaged payouts to boot. To realize those benefits, though, you have to avoid the temptations of buying low and selling high, focusing instead on buying the right company at the right price.
