The Lure Of The MLP
For a tiny part of the market, master limited partnerships (MLPs) inspire plenty of passion.
MLPs are partnerships that trade on stock exchanges. To qualify as an MLP, a company must generate at least 90% of profits from certain qualified sources and pay out most of its cash flow in distributions. The group has attracted a lot of investor interest in the last two years, for some obvious reasons:
• Superior returns. The Alerian MLP Index of 50 prominent energy master limited partnerships has delivered an annualized return of 17.0% since the start of 1996. In contrast, the S&P 500 Energy Sector Index has returned 13.6%, while the broader S&P 500 managed 6.8%.
• High yields. The Alerian MLP Index yields about 5.9%, dwarfing the S&P 500 Index yield of 1.9%.
• Favorable tax treatment. MLPs are not taxed at the corporate level, freeing up more money for distribution to investors. Investors pay taxes only when they receive distributions. Taxes on the bulk of those distributions are generally deferred until the shares are sold, with the remainder taxed at the ordinary-income rate. The unusual nature of MLP distributions can cause extra paperwork and headaches at tax time.
The huge run-up in energy prices in recent years accounted for much of the MLP index's superior performance. U.S. law limits the use of MLPs to certain types of businesses. While some financial and industrial companies are set up as MLPs, companies focused on natural resources account for about 90% of the group's stock-market value, with most of that in energy.
Investor interest in MLPs has increased in recent months — not surprising given the index's return of about 130% since the end of March 2009. Of the roughly nine exchange-traded MLP products on the market, none has three years of history, while seven launched in the last year.
Those exchange-traded products lose some of the MLP's built-in tax advantages. Most are exchange-traded notes — specialized debt securities — for which investors pay tax on all distributions at the ordinary-income rate, losing the deferral benefit. The sole exchange-traded fund, Alerian MLP ETF ($16; AMLP), must pay and withhold income taxes at the corporate level, though only on a portion of the distributions. ETF investors may be eligible for the lower dividend tax rate on their distributions.
We are not enthusiastic about MLPs for at least three reasons:
• Weak QuadrixÂ® scores. MLPs average a Quadrix Overall score of 40 and a Value score of 30.
• Weak Quadrix scores, part II. Quadrix has worked quite well in the MLP space. That suggests that investors would be wise to pay attention when the stocks earn poor scores. Below we list four MLPs that earn high Overall scores.
• High valuation. In the wake of MLPs' strong performance — components of the Alerian index averaged returns of 38% over the last 12 months — the group appears richly valued. Alerian MLPs average a trailing P/E ratio of 26 and average 33% above their five-year norms.
Quadrix works well with MLPs. In rolling 12-month periods since the start of 1998, the top one-fifth of stocks in the Alerian MLP Index as measured by Overall score outperformed the average stock in the index by an average of 5.1% and delivered annualized outperformance of 4.2%. All six of the category scores used to derive the Overall score have predictive power with MLPs.