Master limited partnerships (MLPs) boast three main attractions: high yields, growing distributions and tax-deferral advantages.

— Elliott Gue, MLP Profits

I’ve written extensively about the benefits of investing in master limited partnerships (MLPs), as has Elliott Gue, co-editor of MLP Profits, who states in this article’s introductory quotation that MLPs offer the trifecta of investment success: income, growth, and tax deferral.

Since the beginning of the calendar year, the Alerian MLP Index has outperformed the S&P 500 by more than 20 percentage points:

Source: Bloomberg

Keep in mind that this outperformance is based on a passive MLP index, which includes “the good, the bad, and the ugly” in MLPs. The MLP outperformance would be even greater if you compared the S&P 500 against only those MLPs that Elliott and co-editor Roger Conrad recommend in MLP Profits.

I can’t reveal any of their recommended MLPs, but what I can tell you is that they are virtually all energy-focused companies, primarily midstream pipelines.  As I wrote in Crude Oil is Going to $100 a Barrel, energy is in a long-term bull market due to increasing consumer demand from emerging markets and shrinking supply. MLPs whose businesses are tied to energy are most likely to offer sustainable dividend yields and growth.  Note that when I say “tied to energy” I do not necessarily mean energy prices.

The great thing about midstream pipeline companies is that they primarily make money as toll keepers on energy volumes. Granted, energy producers are incented to push more product through pipelines if energy prices are higher, but pipeline supply is so tight and energy prices are sufficiently high that most pipelines are running near capacity right now. As Elliott Gue of MLP Profits recently wrote to subscribers:

Most master limited partnerships (MLPs) have little business exposure to commodity prices. Pipelines are the most common assets held by MLPs; fees earned on these assets typically depend on the volume of oil or natural gas traveling through their lines, not the value of the commodity itself.

Of course there are MLPs levered to energy prices (e.g., those engaged in “exploration and production” or “gathering and processing”), so if crude oil goes to $100, they will profit handsomely. My point is that energy-focused MLPs are in the sweet spot!

Financial MLPs are a Bad Deal

In contrast, MLPs in non-energy businesses are much less stable and vulnerable to dividend cuts. The main group of non-energy MLPs is the financial MLPs, which are involved in real estate investments and asset management generally. Not surprisingly, these MLPs have been a disaster since the 2008 financial crisis.  Since the stock market peaked in October 2007, financial MLPs have severely underperformed the S&P 500:

Financial MLP Underperformance: Oct. 12, 2007 through Dec. 3, 2010

Source: Bloomberg * Och-Ziff went public on Nov. 14, 2007.

As bad as financial MLPs have performed, things could get even worse: the Obama administration and the U.S. Senate (Sections 401-02 of Senate Bill No. 3793) are both pushing legislation that would tax “carried interest”– a form of compensation paid to a partnership’s managers in exchange for their services — as ordinary income instead of capital gains. Roger Conrad of MLP Profits has written recently that changing the tax treatment of carried interest would be “fatal” to many financial MLPs. While such a tax would not directly affect taxes paid by investors, it could cause the fund managers to demand a greater share of the MLP’s income to make them whole, or they could just decide that the MLP business structure is simply not viable.

Either way, investors in financial MLPs would be hurt if this “carried interest” legislation is enacted into law. Stephen Schwarzman, CEO of the Blackstone Group, is so incensed over the carried interest legislation that he has likened President Obama to Hitler invading Poland.  He dislikes Obama so much that he is leaving the country and moving to Paris.

The good thing about investing in energy-focused MLPs is that this “carried interest” tax issue is, well, a non-issue. As Elliott Gue of MLP Profits states:

Energy MLPs represent operating businesses; the carried interest income they generate isn’t capital gains and has always been taxed at ordinary income tax rates. Managers don’t pay the lower capital gains tax rates on their IDRs at the current time, so this law wouldn’t affect their taxation one bit.

Even without a change in carried-interest taxation, financial MLPs have not paid investors sustainable dividend yields. Many have cut their dividends substantially. Just look at the pitiful yields currently paid by some financial MLPs:

Source: Yahoo! Finance

In conclusion, none of the financial MLPs should be bought and if you own them they should be sold. As Elliott Gue recently wrote:

Since we started MLP Profits we’ve repeatedly noted that these financial partnerships are in the Obama administration’s crosshairs and that the risk of this sort of legislation loomed. That’s why we’ve rated all of these partnerships “Sell” in our How They Rate table. The bottom line with all of these sell-rated MLPs is there’s nothing worth anyone’s interest.

Real Estate MLPs are Inferior to REITs

Besides financial MLPs, there are other non-energy MLPs that should be avoided. For example, real estate MLPs like NTS Realty Holdings (AMEX: NLP). Although the partnership still pays 5%, it has cut its dividend several times recently and its stock has lost 7% this year, more than negating the dividend that remains. It’s hard to believe any MLP could lose money this year when the MLP index is up more than 32%. As Roger Conrad put it recently:

If you want to buy securitized property, buy a real estate investment trust (REIT), not an MLP that would be blown ski-high by a change in tax law.

MLP Profits rates NTS Realty a “sell.”

Grandfathered MLPs and Others are Just Plain Weird

Lastly, there are three MLPs engaged in “other businesses” that don’t seem to fit into any of the permitted business categories allowed by Congress. At least one (Cedar Fair) is allowed to operate in the tax-advantaged MLP structure as a “grandfathered” entity because it existed prior to the 1987 law limiting MLPs to businesses involving natural resources (including oil and natural gas), real estate, and commodities. Below are the three:

Macadamia Orchards is a bad investment because it doesn’t pay a dividend. Cedar Fair pays a decent dividend now, but it has a heavy debt load caused by an unwise acquisition and was forced to temporarily discontinue its dividend this past February. Grandfathered MLPs like Cedar Fair also suffer the burden of having to pay a 3.5% tax on gross income that other MLPs don’t have to pay. Lastly, according to Roger Conrad, StoneMor “covers its payout only thinly” and is a “potential graveyard of capital.”

Stick with Energy-Focused MLPs

Energy MLPs have performed spectacularly this year and are the type of MLP most likely to continue outperforming in the future. To find out the specific names of the energy MLPs Roger and Elliott like most right now, give MLP Profits a try today!