One, two, three, four: what was the safety ratings system for?

It was intended to gauge the reliability of the distribution, during a bull market that made distribution cuts more rare than meteor showers, because in a pinch a partnership could always sell more debt or equity.

Awarding points based on pre-set rules had the advantage of clarity, the appearance of precision and the sheen of prudence.

Except that when it came to anticipating the two MLP distribution cuts that have actually taken place over the last 18 months, the safety ratings failed. (For more on why, see “No Safety in a Number” from the April issue.)

What didn’t fail, what led us to urge subscribers to sell those holdings before disaster struck, was paying attention to some warning signs that were harder to quantify, like disclosures in Securities and Exchange Commission filings and the tone of management on the conference calls.

In fact, the more we saw the ratings dictated by the system the more we became convinced that we can do better. For starters, it’s time to admit, with recent market turmoil as a timely reminder, that distribution cuts are not the only hazard facing MLP investors, that even without those the price of these securities can and sometimes does decline dramatically.

The revised allocations of our picks among the Conservative, Growth and Aggressive portfolios will from now on reflect the progressive levels of risk not just to the distribution but to invested capital. The Conservative Portfolio is obviously for the safest bets, while the Aggressive Portfolio is for the riskiest (but with the increased upside to match.)

Are three risk levels better or worse than four? I don’t think that matters. What does matter is not coming to believe that a single number or label is all you need to make a judgment about risk. With that in mind, we’re following up on the diagnostic first performed in March (“Introducing the Annual Checkup“) to provide updated metrics on the distribution coverage and debt leverage of every current recommendation.

We believe that cash earnings retained by a partnership can provide an essential safety margin should business fundamentals weaken, and also minimize the need to finance growth with equity and debt. That’s why the distribution coverage ratio, dividing the available cash earnings by the distributions declared, is worth paying attention to in its own right, rather than just as a component of a rating system.

Similarly, the ratio of a partnership’s net debt to its cash earnings, often based on Ebitda (earnings before interest, taxes, depreciation and amortization) is an important measure of financial flexibility. This ratio’s progression over time can flag managers fueling growth with an unsustainable accumulation of debt.

The figures below were compiled overwhelmingly from the securities filings of the companies and MLPs. The goal was not only to compile statistics more reliable than what Bloomberg or other data providers can offer, but also to permit apple-to-apple comparisons between our picks. Except as noted, the ratios are based on the annualized results from the past two quarters. This way we’re picking up where the March checkup left off by focusing only on this year’s trend, without entirely falling prey to the seasonal or business volatility that can affect results in any given three-month period.




The bottom line to this exercise is that the overwhelming majority of the MLPs we track appear to have the necessary safety margin to shake off the recent volatility in crude and equities and to continue generously rewarding investors. But a few are changing portfolios to properly denote their risk and a few others will be checking out altogether. Please see Portfolio Update for all the details.

Between subtracting several high-risk partnerships and adding two new recommendations with some of the best financial metrics in the field, we’re confident we’ve just improved the overall quality of the portfolios. And we hope you will agree that assessing multiple financial risk metrics and being able to compare them among MLPs beats investing based on a single number.