Jason Stipp: I'm Jason Stipp for Morningstar. One investment we're hearing about perhaps more than just about any other is MLPs, Master Limited Partnerships.
Here with me to talk about what all the buzz is about and if there are any attractive ideas in MLPs is Paul Larson. He is editor of Morningstar StockInvestor and an equity strategist.
Thanks for joining me, Paul.
Paul Larson: Thanks for having me.
Stipp: So, this is an investment we get e-mails about, we hear about on the Morningstar boards. What is all the buzz about? What's attracting people to this investment vehicle right now?
Larson: Well, I think it's the low interest rate environment that is driving people towards this investment class, which, all else equal, has very high yields on these investments.
It's very interesting because a couple of years ago, two, three years ago, we were recommending a large number of these MLPs and because of the tax considerations, the tax complexities around these, people looked at that and said, no, it's too much work, too complex, move on.
But it's amazing, what a low-yield environment will do to people's sentiment. Now we're saying, okay or they're saying, okay, it's 7%-8% yield. Tell me more. I will look beyond the tax complexities and actually do the homework and the extra tax work.
Stipp: So, certainly, I think any kind of income-generating investment right now is garnering some attention, since folks as you said aren't getting a lot of income elsewhere in other parts of the market. So, what exactly is behind that? What is an MLP? Why does it pay out this income, and what kind of business is underlying that?
Larson: Right. Well, MLPs are a little bit different than the regular C corporations because they are partnerships, they are pass-through entities. They don't pay corporate income taxes. That tax liability is actually flowed down to the individual owners.
The vast majority of the cases are in the energy space, typically the energy transportation space. These are infrastructure businesses--businesses that we tend to think have wide economic moats or in a worst case relatively high-quality narrow economic moat in a lot of these cases, and they are relatively attractive and steady businesses.
Stipp: So, is there a reason why that type of business, the transportation of energy, pipelines and whatnot, is good for this particular business structure? I mean, why is that, that you do see most MLPs are these types of energy transportation businesses?
Larson: It's actually because they are given this tax break of not having the corporate income tax and tax law limits the number of businesses or the types of businesses that are allowed to form under this. There are a handful of non-energy transport MLPs that have been grandfathered in, but it's a very small number and shrinking.
Stipp: Okay. You mentioned earlier that one of the reasons that before we had seen not a whole lot of interest in these investments was because there are some special considerations, especially on the tax front. So, we know a lot of folks are looking at them now, what are some of the things they should be thinking about if they want to buy an MLP?
Larson: The one thing that I should stress if people are not going to remember anything else from this video, is that you should not buy MLPs in a qualified account, such as your IRA or 401(k). There's nothing preventing you from doing it. Your broker won't stop you from doing it if you put an order in, but if you do this you could be opening yourself up to a tax headache in a major way, because if your investment in MLPs generates over $1,000 in what they call unrelated business taxable income, the IRA or 401(k) itself could owe taxes on that income that is generated--not you as the beneficiary of the account, but the actual account itself. It's just a tax headache that you don't want to approach.
Stipp: Well, I I've got to tell you, Paul, it's making my head hurt just you talking about it, right now. So, certainly something, I think that investors would just want to avoid, since this is so easy to not put them in one of those accounts.
Larson: Right. And another reason to put them in a taxable account is because these are somewhat tax-advantaged investments, because the income that they generate is actually a typically much smaller portion than the actual cash distribution that one receives, and that difference is considered a return of capital, and it's deferred income. And all else equal, paying income further in the future on that amount is better than paying it today. So, again, with a tax-advantaged entity, put it in a taxable account.
Stipp: So, very, very key. Keep them out of your tax-advantaged accounts.
So, give me a sense then, these are income generating investments, what kind of yields have they been paying? And how have we seen their performance--if people have been buying these up, I assume that yields probably come down a little bit and their market values have gone up. What have we seen on the performance front for these investments?
Larson: Right. The yield was quite attractive a year or two ago. We are talking 8% to 10% for the vast majority of these on the yield, but they have done exceptionally well. We recently launched an MLP Composite Index and the one-year performance on that is 50%, which is just phenomenal. And looking over a three-year period on the same index on an annualized basis, this MLP index has a positive 13% on an annualized basis.
So, the yields have indeed come down. They've gone from the 8% to 10% range to the 4% to 6% range today, which is still a lot better than you're going to get in alternative investments, but low relative to recent history.
Stipp: So, given that we have seen a pretty substantial run-up in these investments, are there any attractive ones today? Obviously, people are still out there looking for income and as you said the yields are still better than you might get elsewhere. What's on the radar right now? Is there anything that's worth buying?
Larson: Right. The vast majority attain our 3-star rating. They are right in the neighborhood of fairly valued. We do have one idea, it's not a 5-star stock, its only a 4-star stock but it's our best idea in the group, and it's a company called Energy Transfer Equity, with the ticker ETE.
This is something of an investment company, a holding company. They own the general partner of two other MLPs, Energy Transfer Partners, ticker ETP, and Regency Energy Partners, which is a much smaller portion. These are natural gas transportation businesses, and ETP also owns a propane distribution business. They are number-three propane distributor in the country. Relatively steady businesses, and ETE is one of the few that really hasn't had that massive run. It's still yielding a little under 6%, and the stock is a decent way under its $51 fair value estimate, and I think it's the most attractive MLP today.
Stipp: Is there reason that that one hasn't run up quite as much or is there some concern out there in the marketplace over it for any particular reason that maybe we think is overblown?
Larson: I think there is a little bit of complexity around this business model because they do own the general partner of other MLPs and then in turn, there is another MLP that owns a good chunk of ETE, and you look at the org chart and it very quickly gives you a headache.
So, there is a lot of complexity that I think turns investors off, but I think once you work through it and see what you are actually buying, much like we experienced with another MLP that owns general partners of other MLPs, a company called Enterprise GP Holdings. This is one I actually owned in the Hare Portfolio in StockInvestor, and it has done very well, just got a buyout offer. And with Energy Transfer Equity, it's a similar situation, and I think it's going to do well in the future.
Stipp: You also mentioned to me--given that, obviously, the number of attractive ideas in the MLP space is pretty limited right now--that you had some alternatives that investors might consider. What are those?
Larson: One is TransCanada. It's a pipeline company. Its not structured as a MLP. It's a traditional company up in Canada, but it is in the MLP-like businesses, the pipeline infrastructure, very stable businesses, relatively high-yield near 5% and without all the tax headaches that are associated with an MLP, and it is slightly undervalued. Our fair value estimate is $43 versus the stock that's around 37%.
Another alternative is Kinder Morgan Management, and this is a company that is basically a different share class of one of the largest MLPs, Kinder Morgan Energy Partners. And when you buy Kinder Morgan Management, ticker KMR, you get your distributions in additional shares every quarter as opposed to getting your partnership distributions in cash. And if one wanted to generate income, they could in theory sell off those additional shares that they are getting every single quarter to generate that income.
And unlike KMP, which is an MLP, KMR is structured as a traditional corporation. So, you can indeed buy this in the qualified account, or buy it in the taxable account and not have the tax reporting requirements.
Stipp: Well, Paul, thanks for the ideas, thanks for your alternative suggestions, and thank you for the context around this very, very hot investment type today.
Larson: Thanks for having me.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.