Confusion and misunderstanding can provide opportunities for those who are willing to make the effort to dig into the detail and learn the fundamentals of difficult topics.
Like a befuddled 7th grader whose eyes glaze over when the math teacher first broaches the subject of algebra, many investors shy away from Master Limited Partnerships because they do not fit the norm for stock investments, have yields that are "too high," are not measured by the same metrics as other equities, may not be appropriate for IRAs, and generally are "more difficult" to understand than their other investments.
However, for those willing to take the time to study a little bit, they will find that the world of MLPs is not all that complicated and can offer a wonderful opportunity for a long term steady and growing income.
First of all, what is a Master Limited Partnership? Master Limited Partnerships were established within the US Tax Code to enable smaller investors to participate in operations with very expensive up front costs such as oil and gas pipelines that would be out of reach for the average investor without such a partnership arrangement.
Companies that choose to operate as MLPs tend to be large, slow growing and stable and often have a monopoly within the territory that they operate.
The assets generally produce a consistent cash flow, but growth is slow and limited to purchases of like facilities or new construction.
MLPs don't pay any corporate taxes, (often yielding higher returns as a result), rather income goes directly to the unit holders pro rated by the number of units they hold, and the unit holder is taxed at the individual's tax rate.
Each unit holder is a limited partner while the operation of the business is handled by the general partner.
Not every company can qualify as an MLP.
First the company must earn 90% or more of its income from natural resources (energy, mining, timber), minerals, commodities, real estate, real estate rents, or gains from dividends and interest.
However, most MLPs currently are in the energy area, specifically in oil products pipelines and natural gas pipelines.
Generally oil product pipeline MLPs receive regulated fees for the transportation of product and are paid on volume unrelated to the price of the product being transported.
This tends to make them more stable.
Natural gas pipeline operators also frequently run the gas gathering function as well which gives them exposure to the fluctuations in natural gas pricing.
Many gas MLPs reduce the impact of price changes by hedging thereby establishing a more predictable cash flow.
MLPs make quarterly distributions which seem similar to stock dividends however they are quite different.
Typically a quarterly distribution is classified as partially net income, and partially a return of capital (in the world of MLPs this return of capital is another name for depreciation or a depletion allowance).
Generally, the Return of Capital represents the lion's share of the distribution.
The income portion of the distribution is taxed at the individual's normal tax rate while the return of capital segment reduces the cost basis.
This means that you don't pay any taxes on the majority of the distribution until such time as you sell the units.
In a regular taxable account this makes MLPs ideal for both long term investors and folks who plan on leaving their units to their heirs.
In an IRA, or other tax deferred accounts, there is one additional complication.
That is, the smaller segment of the distribution that is treated as net income is classified as UBTI (Unrelated Business Taxable Income) and if this portion exceeds $1000 annually it is subject to income tax even in a tax deferred account, such as an IRA, forcing the IRA to file a tax return.
This problem is non existent for the average investor where the UBTI will generally fall below the $1000 barrier.
For investors with hundreds of thousands of dollars invested in MLPs in their IRAs, UBTI may be a more important factor.
For those who are unsure it is important to seek tax advice from a CPA or other tax specialist.
Evaluating an MLP is different than evaluating a typical stock.
Because of the huge outlays in capital equipment, and resultant typically large depreciation expenses, the typical earnings metrics are not appropriate for evaluating an MLP.
Distributable cash flow is the most important single factor in evaluating whether or not an MLP is appropriate for you.
It is the source for paying the quarterly distributions and provides cash for future expansion.
It is important to determine how consistent the distributable cash flow has been, and whether or not it has grown.
For example, Kinder Morgan Energy Partners, one of the best known MLPs paid $0.
475 per quarter in 2001, and just recently announced that it will be paying $1.
10 per quarter in 2010 up from $1.
05 per quarter in 2009.
It is this type of consistent growth in distributions that have made MLPs a favorite of the more sophisticated yield investor.
Finally, if you want to invest in MLPs but don't want to deal with any of the tax ramifications, there is an ETF (exchange traded fund) that allows you to invest in a pool of MLPs without any of the above mentioned tax considerations in either a taxable account or a tax deferred account: AMJ.
But if you invest there you miss all the fun of doing your own analysis and choosing which MLPs best fit your investment objectives.
Just as with any investment, past performance is not guarantee of future results.
There are a lot of MLPs out there and while some have performed very well in the past, others have failed.
It is important to do your due diligence, and select those that meet your own personal criteria and tolerance for risk.
If you do, I think that you will find a place for MLPs as part of a balanced and diversified portfolio.