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MLPs: Still a Land of Fertile Yields

They won't keep outperforming, but the dividends are lush


Are MLPs still a good investment? For those of you who need a one-word answer, I would have to say “yes.”

Given the pricing of other income-oriented investments, master limited partnerships still are some of the best deals out there for long-term inflation-beating returns. And when you take into consideration that the rich cash distributions often end up being effectively tax-free because of depreciation expenses and other charges, the story gets even more compelling.

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It might be a tad unrealistic to expect MLPs to continue the stellar returns of recent years; however, $1,000 invested in the Alerian MLP Index 10 years ago would have grown to nearly $4,500 today with distributions reinvested. That amounts to 16% annualized returns in one of the worst decades in the two-century history of the U.S. stock market.

Over the same period of time, a $1,000 investment in the S&P 500 index with dividends reinvested would have grown to less than $1,500. The amounts to an annualized return of 4.1%, which doesn’t take into account the taxes that would have been paid on dividends by taxable investors.

Going forward, I do not expect this kind of outperformance. Ten years ago, MLPs were cheap. You easily could assemble a portfolio yielding 8% to 10% without taking excessive risks. Today, the index yields around 6% and many of the blue-chip names yield substantially less.

Enterprise Products Partners (NYSE:EPD), considered by many to be the best-managed MLP in the sector, yields just 4.9%. Kinder Morgan Energy Partners (NYSE:KMP), another popular MLP with investors, pays 5.7% but with less possibility of distribution increases going forward.

As a side note, investors would have better potential returns going with KMP’s sister stock, Kinder Morgan Management (NYSE:KMR). KMR pays its distribution in stock rather than cash, avoiding some of the potential tax pitfalls for IRA investors. KMR’s dividend is currently about 10% higher than KMP’s.

Ten years ago, few in the investment world had ever heard of master limited partnerships, and income-oriented investors had their choice of bonds that paid respectable yields. Flash forward to today, and MLPs are well-known by virtually any experienced investor. Professional interest also has grown by leaps and bounds; my hometown of Dallas is home to several well-respected hedge funds that invest heavily in the sector.

Looking at equities, we see quite the opposite. Ten years ago, everyone wanted to be a dot-com millionaire. The market “always” went up. Unless you were in or near retirement, you generally didn’t give much of a thought to income.

Stocks also were very expensive, just coming off of an 18-year bull market that saw the dividend yield shrink by more than two-thirds and the price/earnings ratio more than triple. Stocks were priced to underperform going forward, and they did exactly that.

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Looking at Figure 2, one point immediately jumps off the page. Even while dividends are becoming more and more popular with investors in recent years, the yield on the broad S&P 500 barely cracks 2%. It’s possible — and even easy — to build a portfolio of individual S&P 500 stocks that yields 4% to 5%, but cracking the 6% yield offered by the competing MLPs would be difficult to do while maintaining portfolio quality.

So, for most income investors, MLPs remain more attractive that the broader stock markets.

Of course, as investors, no one said we can’t have both, and that is precisely what I recommend. A portfolio spread between high-quality dividend-paying stocks, MLPs and REITs offers the potential for decent returns during the next decade regardless of what happens in the stock market.

In an unstable and volatile market, it pays to get paid.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”

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