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Big Yield Hunting

By Roger Conrad on March 5, 2010

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Everyone wants to buy into a big yield. The trouble is most people aren’t willing to put in the time to tell the good from the bad and ugly. As a result, they’re either overly skeptical–thereby missing out on what would otherwise be an ideal investment–or gullible, in which case they’re liable to make even worse moves.

At this point, two investment classes stand out for their high yields: Canadian trusts and master limited partnerships, or MLPs. A fair chunk of the questions I get from readers are concerned focus on which option is “better” for them. And everyone always wants to know the pros and cons of one versus the other.

Unfortunately, that’s missing the point entirely. No one investment “class” is better than any other. Rather, it’s the underlying businesses that finance the dividends paid by MLPs and Canadian trusts that are the clear line of demarcation, and where investors need to focus their efforts.

My colleague Elliott Gue and I cover every US MLP in our advisory MLP Profits, and we rate roughly one-third of them as sells. Some should be avoided on the basis that their underlying businesses are chronically weak. Others are in danger of running afoul of the continued push in Washington to slam the door on “carried interest.”

Carried interest is a method of avoiding taxes used by hedge funds as well as pseudo MLPs like widely touted AllianceBernstein Holding LP (NYSE: AB). The MLP has recovered from its low of a year ago of barely $10 a unit. But it will give that up and a lot more if Congress again takes up this intensely populist measure in an election year.

Unfortunately, your average investor in MLPs sees a tax advantaged yield and little else. As a result, they’re drawn like a magnet to the likes of Capital Products Partners LP (NSDQ: CPLP) and the ever popular Cheniere Energy Partners LP (NYSE: CQP). Few have the slightest inkling that one of them has already cut its distribution once in recent months, while the other has a near bankrupt general partner.

To be sure, there are also staggering opportunities in the MLP space. The proliferation of shale gas plays in the US has triggered a phenomenal increase in demand for new natural gas infrastructure, from gathering systems and processing facilities to interstate pipelines and storage systems.

As Elliott points out in his advisory The Energy Strategist, demand for US natural gas liquids (NGL) has exploded, as NGLs gain appeal as an alternative to oil both in the US and abroad, particularly in Asia. NGLs are much cheaper than oil, largely because their feedstock natural gas is so cheap relative to oil. And with the country awash in shale gas and developing Asia demanding more oil than ever before, that price gap is unlikely to change anytime soon.

The result is growing demand for NGL infrastructure, as well as other types of natural gas infrastructure. And the primary players providing it are selected master limited partnerships, which will see continued and robust growth in cash flows and distributions for years to come. The shame is many investors will never hear of this opportunity, as they’re seduced merely by yield.

As for Canadian income trusts, they were the top-performing income investing group in 2009 and have outperformed thus far in 2010 as well. Nonetheless, even companies that have never cut their distributions continue to throw off yields of 9 to 10 percent, and some even more.

The reason: Continued overblown fears about trusts’ ongoing conversion to corporations. That’s in large part the direct result of willful ignorance on the part of many so-called experts on both sides of the border. And the result is many are missing out on an historic opportunity to score explosive gains.

Since the tax on trusts was first announced Halloween night 2006, the conventional wisdom has been that trust conversions to corporations are a final disaster for investors, featuring steep dividend cuts, plunging stock prices and even liquidations. Yet as I’ve pointed out in Canadian Edge, the 26 trusts that have completed conversions to date have returned an average of 63 percent from the day before they announced. Another 19 that have announced but not completed conversions are up an average of 23 percent over an average holding period of just a couple of months.

As for dividends, half of the companies that have announced and/or completed conversions haven’t cut their distributions one penny. Baytex Energy Trust (TSX: BTE-U, NYSE: BTE) actually increased its dividend by 50 percent when it announced its conversion last year. And even those that have cut distributions are doing so in amounts that are far less than what’s been priced in, triggering share price gains.

The upshot: Not only have trust conversions not been a doomsday. But many have actually generated windfall gains. You’d never know that, however, unless you took a little time to look past the yield and at the underlying business. That’s the key to successful big yield hunting, no matter sector you’re looking in.

Question of the Week

Here’s a frequent query I received last week. Please send your questions to utilityandincome@kci-com.com.

  • I’ve made some big time gains over the past year in Canadian income trusts, master limited partnerships and other income stocks in the past year. But the weak economy and what’s happening in Washington have made me very nervous and I’m afraid we’re headed for another big crash. Do you have any advice on when it would be a good time to sell?

Whether you’re a conservative income investor, an aggressive yield-seeker, a growth investor or a speculator, you should always sell if one of two things happens: you realize a massive profit that’s not matched by positive developments in the underlying business of the stock you’re holding, or the underlying business of your stock deteriorates.

Other than that, my best advice is to employ some discipline that will take the emotion out of your decisions. The worst mistake most people made during the downturn of late 2008 and early 2009 wasn’t being in the market when Lehman Brothers failed. It wasn’t even riding down positions on those gut-wrenching days when the market was routinely falling several hundred points as panic swept Wall Street.

Rather, it was giving up on good positions because they just couldn’t take the pounding. Emotion is certainly a part of the market, if not the most important part. Investors get greedy when prices are rising and fearful when they fall. And the worst offenders are not individuals but the people running the big money through institutions like mutual funds, insurance companies and other vehicles.

As I’ve pointed out to readers many times in the past, these people have a fundamentally different set of investment objectives than individuals do. Sure they want to make money just like everyone else, and they’re likely to be more knowledgeable about investment alternatives than most individuals as well. But most are also on a very short leash in terms of performance, with a bad quarter or a bad year making the difference between a big bonus and getting fired. That makes them very short-term minded.

As an individual, there’s no cutoff date for portfolio performance. How you’re faring at the open on January 5 is much more important than where you were at the close on December 31. Not so for the people who run the institutions. They have to meet those dates, and when they all lean one way, they pull the market along with them.

I’m a believer in taking money off the table periodically in a stock that’s really rallied for you, and then letting your investment run. I think this may be a very good time to do that for particularly big gains. I’m also a believer in periodically rebalancing your holdings.

An ideal income portfolio, for example, will have a broad mix of yield-paying investments, with no one sector accounting for more than 20 to 25 percent of the total portfolio. If a particular stock or sector grows to too large a portion of your holdings, it has the power to drag your net worth down significantly should something unexpectedly go wrong. Rebalancing not only locks in a big gain, but more importantly it limits this kind of unique risk.

All of these are of course very general rules about portfolio management. But they’re also ways you can take the emotion out of investing, which is your greatest enemy.

As for where things are headed with the broad economy, I see points of strength as well as weaknesses. That kind of market usually means the risk of individual companies blowing up is greater than the risk of an overall market meltdown. That makes it very important to sell companies when they weaken as businesses, no matter how long you’ve owned them, or whether you have a profit or loss.

It also means, however, that you’re better off sticking with companies whose underlying businesses remain solid. That especially goes for any investment that weathered the late 2008, early 2009 meltdown without a dividend cut or weakening earnings. They’ve proven themselves in the worst possible conditions, and that’s the best possible indication they’ll be able to do so again. And if you’re wrong and we do avoid a meltdown, they’re your highest percentage to building and rebuilding wealth–which you’re definitely not going to do if you’re out of the market and in cash yielding less than 1 percent.

Race to the Summit

How best to ride this market? Join me and my colleagues GS Early, Elliott Gue, Yiannis Mostrous, and Benjamin Shepherd at the historic Hotel del Coronado for the 2010 Wealth Society Member Summit.

You’ll have the extraordinary opportunity to meet one-on-one with me, Elliott Gue, Yiannis Mostrous, Benjamin Shepherd and GS Early and ask anything you want about how to keep and grow your nest egg.

We’ll give it to you straight: the brightest trends and our best recommendations, and anything else you might want to know about how to profit in 2010 and beyond.

Space and time limit us to 100 participants, so mark the date on your calendar: April 23-24, 2010, in San Diego, where they say it’s 72 and sunny every day of the year. You may find all details at www.InvestingSummit.com. Better yet, call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table.

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