Buying a business is a great way to get rich.
Not only are business owners entitled to a portion of their company's profit, but those profits are frequently classified as distributions, so they're taxed at a lower capital gains rate. That's a powerful income and tax strategy for generating long-term wealth.
But owning a business also involves plenty of risk. Buying a business is a capital-intensive feat and, because businesses are illiquid assets, it's difficult for owners to access equity when it's time to sell. And when you throw in expensive transaction costs for attorneys, consultants and contracts, it's easy to become uninterested by the high financial hurdles that are in the path to business ownership.
That's why master limited partnerships (MLPs) are becoming so popular. An MLP provides investors with the liquidity of a stock and the benefits of business ownership. In other words, MLPs work just like corporations, with the only difference being taxation. In fact, MLPs are required to pay 90% of their income as distributions to their limited partners, the shareholders. These distributions are only taxable when the units are sold (ownership in an MLP is in "units" rather than shares.).
That's why it's a good idea to hold the units for longer periods or even up to retirement, when retirees typically move to a lower tax bracket. For that reason, Carla Pasternak, Chief Investment Strategist of High-Yield Investing, calls stocks like these "Retirement Savings Stocks."
Because of this huge tax-saving trait and their high yields, there have been huge capital inflows into MLPs in the past few years. Take a look at the big gains in the JP Morgan Alerian MLP Index ETN (MYSE: AMJ), an exchange-traded note (ETN) that tracks the Alerian Index of MLPs (master limited partnerships).
But in spite of those big gains, there are still incredible high yields in the MLP space. In fact, it's not uncommon for MLPs to carry dividend yields of above 8%, more than four times the yield of the 10-year U.S. Treasury note.
MLPs are widely found in the energy industry, particularly in the pipeline industry. In the past few years, many large energy companies have spun their pipeline operations off as MLPs to entice public capital and catch a break on taxes.
Here are four of my favorite picks in the pipeline MLP space.
1. El Paso Pipeline Partners L.P. (NYSE: EPB)
Market cap: $8 billion
El Paso Pipeline Partners is a solid mid-size player in the mid-stream space, with a market cap of $8 billion. The company's vast pipeline network is heavily concentrated in western states such as Colorado and Wyoming, providing it with leveraged exposure to the key Bakken and Barnett shale gas plays in Texas, and North and South Dakota.
That's one of the reasons Goldman Sachs recently expressed a more bullish view on the mid-stream pipeline group, making note of high yields after prices fell sharply on the year and exposure to growth in the booming shale industry. The limited partnership has a 6% dividend yield and forward price-to-earnings (P/E) ratio of just 18, which is a discount to the industry average of 26.
Kinder Morgan is the biggest pipeline MLP of the group, with a market cap of $28 billion. But the company's size hasn't prevented it from staying nimble and profitable in the dynamic pipeline space, recently delivering strong third-quarter results that met expectations.
Kinder Morgan has now raised its quarterly cash distribution 45 times since the current management took over in 1997. The company plans to declare cash distributions of $5.28 per unit in 2013, a 6% increase from the $4.98 per unit it expects to declare this year. This is another pipeline MLP that offers strong exposure to the shale gas boom, in key plays such as Eagle Ford and Haynesville. And with a solid dividend yield of roughly 6%, it's easy to see why investors have been flocking to Kinder Morgan.
3. Buckeye Partners LP (NYSE: BPL)
Market cap: $4.9 billion
Buckeye Partners is a mid-sized-player in the pipeline space with a market cap of nearly $5 billion. A company this size can grow through capacity expansion and as a potential target for acquisition. Buckeye specializes in refined petroleum products with major operations in the northeastern United States servicing industrial hubs like airports and government facilities.
After delivering strong third-quarter results, analysts have become more bullish on the MLP, lifting their full-year earnings estimate 5% to $2.82 a share. This bullish tone also flowed into the next-year estimates, with analysts looking for 19% earnings growth in 2013, slightly ahead of the industry average of 17.6%. Buckeye has fallen 22% on the year, but this price drop has sweetened the dividend yield to an outsized 8.3%. With earnings on the rise and a bullish growth projection for next year, this MLP is looking strong.
4. William Companies Inc. (NYSE: WMB)
Market cap: $21 billion
Williams Companies is a bit of a hybrid in the pipeline space, with an exploration and production division complementing one of the largest pipeline systems in the country. That creates some segment diversification, but this also weighed heavily on earnings when natural gas prices collapsed below $2 per million British thermal units (Btu). With natural gas prices rebounding sharply in the past few months, William Companies provides leveraged exposure to the resurgence in the commodity.
Shares are up 22% on the year, one of the top-performing stocks in the pipeline and exploration space. But in spite of these gains, the company still carries a healthy 4% dividend yield that is more than two times that of the 10-year Treasury note.
Risks to Consider: Pipeline companies are capital-intensive businesses. They tend to carry large amounts of debt on the balance sheet, making them vulnerable to weakness in economic growth and overcapacities in the industry.
Action to Take --> MLPs are a great way to combine the benefits of business ownership with the liquidity of stocks. This rare combination has driven sharp capital inflows into the group in the past two years. In spite of these gains, yields are still sky-high, making this a great time to take a serious look at these yield-hogs with the potential for serious long-term capital gains as the shale boom and growing energy demand fuels the industry.