Personal Finance

3 Investing Tips for MLPs That Could Earn You Thousands

Growing plants on ever larger stacks of coins.

Master Limited Partnerships -- MLPs for short -- are one of those unique subsets of stocks you can buy. For income investors and those that have an affinity for high yields, MLPs are like going to the candy store. This unique corporate structure is designed to deliver large amounts of cash back to investors.

Because of their unique structure, investors need to pay attention to some particular things when buying MLPs. Otherwise, they could be stuck with an investment that looks like a high yield gem but ends up destroying value over time. So here are three tips all investors should know that will help them make better decisions when it comes to buying MLPs.

Growing plants on ever larger stacks of coins.

Image source: Getty Images.

Protected revenue is an investor's best friend

To be a master limited partnership in the first place, a company has to meet certain criteria such as how it generates revenue. Those revenue sources are limited to interest, dividends, capital gains, rental income, real estate, and commodities. The most common master limited partnership, though, is in natural resources.

The overarching goal for these kinds of investments is for a stable high yield. However, natural resources and commodities are by their very nature cyclical industries. The only way for a master limited partnership to reconcile these two diametrically opposed ideas is by protecting revenue streams through contract structures.

The way in which a master limited partnership writes its contracts with its customers will have a huge impact on its results. For any company involved in the production or extraction of a product, long-term supply contracts with fixed prices or some price minimum will help ensure enough cash is coming in the door to pay investors. This can be extremely challenging in more liquid markets like oil & gas or coal. These companies try to protect revenue through hedging strategies and futures contracts, but it's almost impossible to write futures contracts in the oil industry several years in advance. That's a large reason why we have seen fewer and fewer exploration & production companies use the MLP model.

A good rule of thumb for investors is to look for MLPs that have more than 80% of their revenue locked into contracts with fixed prices. An added bonus is when those fixed price contracts also have minimum service requirements like a set volume. These higher levels of contract protection lower the risk of declining revenue that could compromise an MLP's payout.

Capital allocation counts for everything

When a regular company pays a dividend, it puts an added onus on management to be good capital allocators. They have to make sure that the money they invest will provide adequate returns to grow the business and provide enough excess return to give back to shareholders.

When it comes to master limited partnerships, the onus on management is even greater because MLPs typically have such high yields. If that wasn't challenging enough, most investments that MLPs make are capital intense, long life assets that will generate a rather consistent revenue stream throughout the life of the asset. So to build these assets, it typically involves lots of initial funding through a combination of retained operating cash, debt, or issuing equity.

When the stakes are laid out like this, one would assume that management teams for MLPs would be extremely conservative as they try to balance growing the business, maintaining a reasonable balance sheet, and paying investors a considerable amount of cash. Unfortunately, though, too many management teams act rather flippantly with their capital allocation obligations to shareholders, and that's why we saw 24% of all oil & gas MLPs cut payouts during the most recent oil crash. Too many of them abandoned prudent capital allocation during the first shale boom to grow the business or increase payouts to shareholders at unsustainable rates.

One thing that investors should look for in an MLP is a prudent, disciplined management team. That typically means the company retains some cash each quarter to grow the business and preserve its balance sheet. Two good rules of thumb here are a distribution coverage ratio -- total cash available for distribution divided by total cash paid out -- greater than 1.2 times and a net debt to EBITDA ratio below 4.0 times. If a company maintains an investment grade credit rating, that's an added bonus.

Yield chasing in MLPs is just as stupid as it is with other stocks

It's incredibly tempting for investors in this particular subset of stocks to chase yield. After all, this is supposed to be the subset of the market where you can find high-yield investments. Like all other stock investments, though, an MLP with a high yield does not necessarily mean that it is a better investment. All too often, a high yield can indicate something is wrong with the underlying business and that the current payout isn't on a sound financial footing.

Companies that are paying out more per quarter than what comes in the door start to see yields more than 8%, 9%, or even more. Management teams will try to ease investor concerns that this is a temporary thing and that new projects about to come online will boost operating cash flows. Unfortunately, those cash sources never seem to materialize, or management increases its payout when that new asset comes on line and puts the distribution back into question again.

Here's the thing, plenty of companies in this industry provide favorable yields in excess of 5%. You don't need to chase a higher yield because you are likely going to get a rather favorable total return with an MLP yielding in that 5%-7% range. The more important aspect is to focus on the two things above. If a company has a well-protected revenue stream and its management has a reputation for being good stewards of shareholder capital, then a yield on the lower end for a master limited partnership can end up being a very lucrative investment.

What a Fool believes

Master Limited Partnerships can be a great way to give your portfolio that added income boost. You may have to do a little extra tax paperwork at the end of the year, but the benefits of a high yield investment seem to be well worth the extra paper headaches. As long as investors stick to investing in MLPs that have high rates of contract protected revenue, a prudent capital allocation plan, and avoid the siren call of ultra-high yields, then investments in MLPs over the long term can yield thousands to supplement your income or reinvest in your portfolio .

The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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