What to Buy: Cushing MLP Total Return Fund (NYSE: SRV)

Why Now: Worries about a fiscal cliff in the US and a potential increase in dividend taxes have triggered a wave of selling of high-yield stocks across the board.

Master limited partnerships (MLP) haven’t been spared the carnage, partly on concern they’ll lose their tax advantages as well. The result is closed-end Cushing MLP Total Return Fund (NYSE: SRV)–which owns a diversified basket of mostly energy midstream MLPs–now yields more than 12 percent. Meanwhile, its premium to net asset value (NAV)–which has averaged 25 percent over the past year–is down to about 5 percent.

The fund’s monthly distribution is well protected, covered by the distributions of the MLPs it owns by better than a 1.1-to-1 ratio after fund expenses.

Our bet for the next 12 months is the distribution will hold and the fund’s price will head back toward USD10 per unit, giving us a total return of around 50 percent. Buy Cushing MLP Total Return at or below USD8.

The Story

It’s a short one this time around: Panic has gripped the market.

Roger: David, it looks like selling momentum is once again picking up in this market, and dividend-paying stocks are getting chewed up more than most.

Obviously there are things to worry about here, but the magnitude of this selling looks increasingly divorced from reality.

David: We saw something like this in May, when that early year optimism faded. This, though, looks a lot more like 2011, and if that’s the case it could go on for a while.

Roger: Obviously the concern about a US fiscal cliff is a big factor. And with China no longer growing by leaps and bounds, a self-inflicted recession here from going over the cliff is sure to slow things down in a hurry.

But I sense something more at work here. Mainly, going into this election, a lot of investors were convinced re-electing President Obama would trigger a catastrophe.

Now it looks like they’re dumping what they own and running for the hills.

David: I know you say letting politics dictate to your portfolio is always a lousy idea. But don’t they have a point this time?

What if warring Republicans and Democrats in Washington can’t stop fighting long enough to prevent the country from going over the fiscal cliff?

Can the economy stand that kind of shock, and if it can’t aren’t a lot of these high yield stocks we’ve been writing about in Big Yield Hunting going to be cutting dividends?

Roger: Call me Dr. Pangloss, but I still think there’s going to be a deal on the federal deficit, if not by Jan. 1 then at least shortly afterward. There’s just too much at stake for the politicians, especially for the Republicans in Congress too.

And if there is a deal, it’s going to immediately eliminate a lot of uncertainty that’s dragging down this stock market as well as the US economy in general.

Austerity is not working in Europe, and it won’t do anything but create a lot of misery if it’s adopted here. And people are going to know who’s to blame.

Despite what’s going on now, I really think 2013 could wind up looking a lot like 1993. That’s the year many months of Federal Reserve easing finally took hold and the US economy started to rev up, even though the Clinton administration’s first act was to raise taxes substantially.

David: I like the Candide reference, but I can’t help thinking you’re Panglossian to the point of being obtuse, especially for Big Yield Hunting stocks.

We’re seeing some real damage in our positions now. What if you’re wrong and there is no settlement and the US economy really shifts into reverse? Won’t your 1993 scenario turn into 1937 equally fast?

Roger: Look, I’m really not so blind that I don’t see that as a very real possibility.

Those who bet on politicians to do the rational have often regretted it, and many of these guys know about as much about economics and investing as I do about nuclear physics.

The market right now is certainly telling us that the worst-case is a very real risk. And don’t forget that Washington still has to increase the debt ceiling again before the end of the year to avoid a default.

But I would argue I’m really betting on politicians following their need for self-preservation. If they fail, they’re at the end of their careers.

David: So what should investors do with these Big Yield Hunting positions we have open? A lot of them have lost ground over the past month. But surely if there are real dividend cuts there will be even more damage.

And even in a best-case for the market and the fiscal cliff, isn’t anything we recommend to readers now just going to lose value until there is a deal?

Roger: I wish I could tell you there will be a budget deal next week, along with a bottom for the market. All I can say is the more the market sinks the greater the pressure will be on politicians to do a deal.

So ironically, the worse things get now the sooner the end will come.

But the most important thing is that stocks always recover damage suffered in down markets, provided the underlying company holds together. That’s very hard to remember when a stock is getting the stuffing knocked out of it.

But it proved the case following the crash of 2008 as well as the lesser debacles of 2010 and 2011. We’ve made no bones about the fact that Big Yield Hunting picks are speculations. Hey, we’re trying to buy stuff yielding 10 percent or better, and there’s always a reason when a yield gets that high.

What we’re trying to do is find big yielders that can overcome the challenges that have pushed their yields that high. If they succeed we get a big cash payment and a big capital gain. The other side of that is we often have to live with blood-curdling volatility and sometimes considerable downside as well, even if our picks are holding together as companies.

But so long as the business is still on the right track, the lesson of 2008 is recovery is coming. You’ve got to stick in there. Doing otherwise is just succumbing to fear and locking in your losses.

David: What about a new pick?

Roger: Before we get to that question let’s look at what we have open right now.

David: Well, pretty much all the results are in for the third quarter. And much of it actually looks pretty good, at least based on the numbers.

Capital Products Partners LP (NSDQ: CPLP) got some really good news this week, when its sponsor Capital Maritime & Trading Corp extended charters for two of its Suezmaxes at a rate 45 percent above the market price. That takes a lot of potential pressure off the distribution, which the tanker covered with third quarter distributable cash flow by a solid 1.1-to-1 margin.

That was in line with management guidance, and it shows this company is navigating its way through a very tough market. They’re also still putting more ships in the water, which should at least at some point allow them to raise the distribution again.

Roger: That last point you made is key. I think we should remind readers that we do not recommend anyone ever double up on any of these positions.

But this one still very much fits the mold of our Big Yield Hunting picks, and I think we should keep it as is.

David: What if we cut the buy target back a bit, say to USD7.50?

Roger: That’s fine with me. It may be a while before there’s a real recovery in this stock, as tankers were considered a weak industry even before people started worrying about another recession. There should be plenty of opportunity for those without a position to get in.

Moving along, I really like what we’ve seen in Superior Plus Corp (TSX: SPB, OTC: SUUIF). They got another quarter of solid dividend coverage with adjusted operating cash flow (AOCF), and even some of their more economically sensitive businesses like chemicals and construction seem to be doing well.

They also set some pretty bullish guidance for 2013 of CAD1.65 to CAD1.95 per share of AOCF that leaves room for a lot of debt reduction. We may actually get a dividend boost out of this one before it’s over.

The only problem is while we’re pretty much back to breakeven after a big run this year, it’s well above the buy target we have.

Should we adjust that up and give others a chance to participate, or should we just close it out?

David: My preference in this market is to eliminate positions when they get too far above target. Superior Plus looks a lot more like a conservative growth stock than a real Big Yield Hunting speculation. We’re still going to cover it in Canadian Edge on that basis.

But why don’t we close it out in this speculative portfolio, where it really doesn’t belong now?

Roger: That makes sense, and it’s nice to book a gain at least for those who entered the trade this year.

On the contrary, we have taken a pretty big loss on France Telecom SA (France: FTE, NYSE: FTE). Clearly this company is going to be a survivor of Europe’s austerity push, and we’re still getting a pretty good dividend here, even with the very slight reduction in the September payment.

On the other hand, it’s very hard to see much good coming out of this position, even if growth does pick up in the US. I say we cut our losses and at least wait for a better entry point.

David: Yeah, I agree. We should have done that a long time ago. But with so many stocks yielding more than 10 percent with a lot stronger dividends, there’s really no excuse for sticking around now.

What about BreitBurn Energy Partners LP (NSDQ: BBEP)? They just announced another distribution increase on Halloween. That’s their tenth in a row, and they boosted their capital spending plan for 2012 by more than 10 percent as well.

You’ve got to be impressed by their 29 percent boost in production over the past year, and the fact that cash flow was up 70 percent over that time is a pretty clear sign they’re controlling costs and locking in some good selling prices. They even got a better deal on borrowing costs.

Roger: That’s definitely a departure from the travails of many energy producers. I also like the fact that they’re producing more oil and natural gas liquids and that operating expenses per barrel of oil equivalent produced fell more than 7 percent. They’re getting some good scale advantages it seems.

I think we need to be clear with readers that like every energy producer BreitBurn can only hedge so much energy price exposure. And if there were to be a genuine crash in oil prices, say to USD50 a barrel or less, it’s hard to see this master limited partnership avoiding a dividend cut.

But I’m prepared to stick with it at this point, and we are up about 10 percent from entry.

David: What about QR Energy LP (NYSE: QRE)? Same business and same negative market action, though I thought third-quarter results were actually quite solid.

Roger: They didn’t increase their dividend this quarter, but regular boosts have never been their habit. Also, production was off a percentage point, and distributable cash flow dropped 16 percent sequentially from the second quarter.

David: Yes, but they covered the payout by a solid 1.10-to-1 margin and they’re still buying properties, including long life reserves in the mid-South US just recently.

Oil and natural gas output is 90 percent hedged this year, and 85 percent is hedged through 2014. And operating costs were cut 7 percent sequentially, and full-year guidance looks on track.

Roger: That’s a pretty good case for the company being able to hold its dividend in all but a very bad case for oil prices. And that certainly fits the Big Yield Hunting recommendation profile. The buy target is a bit above the current price, but let’s keep it there at USD21.

My hunch is that if markets improve, this one is going a lot higher than that and fast.

David: We should have taken more of a profit on TABCORP Holdings Ltd (ASX: TAH, OTC: TABCF) earlier this year.

Roger: Well the point is we did take some profit, and this company’s recent drop has a lot more to do with the stock market’s mood than its operations or dividend safety.

David: There is a dispute with the Victorian government over an expired gaming license in the province. But that looks like a lot more potential upside than downside, at least in the share price.

And underlying wagering revenue as the company calls it is tracking at a 4.5 percent growth rate, which is better than most analysts seem to have been projecting. That’s an important distinction to make, as the headline number was actually lower due to the company having a lesser stake in one of its joint ventures.

They also had Internet gambling revenue up 13 percent and nearly tracking last year’s 14.5 percent growth rate despite being a larger operation.

Roger: I think we should keep our wager on this wagering company. There could be more downside, particularly if the Australian dollar retreats against the US dollar, as often happens when the world is worried about recession. But up to USD3.15 looks like a good place to enter.

David: That brings us to Data Group Inc (TSX: DGI, OTC: DGPIF). Management finally told us what they’re going to do with that outrageously large dividend of theirs. They’re cutting from an annual rate of CAD0.6504 to CAD0.30 and going to a quarterly payout policy.

Management said it’s making the cut “to reduce debt to achieve a healthier and more sustainable balance sheet” and “to be positioned to make strategic acquisitions.” That all sounds good, and it’s hard to argue the market was pricing in a cut of that size before the announcement.

The stock, however, has really cratered on the news and the release of earnings.

Roger: It’s certainly not the only high-yield stock to take a hit the past couple weeks. In fact we’ve seen several stocks we track in Canadian Edge that did NOT cut their dividends still give up 50 percent or more of their value in just a few trading days.

This one, however, really is starting to look like another Yellow Media Inc (TSX: YLO, OTC: YLWPF) in the making. For one thing, this move is a departure from previous guidance, which I think explains why there was this kind of drop after the cut announcement.

I’m reasonably sure I’m not the only one thinking this. But I really don’t have any kind of comfort level holding this one any longer.  Yeah, it would have been nice to sell sooner and avoid getting tagged with this loss.

But this is the kind of bet we make and it’s better to cut losses with the stock at USD2 than at a much lower level if there’s more bad news ahead. We can always get back in.

David: That makes sense. And our readers can use the tax loss to offset the gains from selling half their CSR Ltd (ASX: CSR, OTC: CSRLF). The stock really hasn’t lost much over the past month, despite a very choppy market.

And the reason is clearly that it’s putting up better than expected numbers. In actual fact, the most recent report wasn’t all that great, but it’s all about beating expectations, isn’t it?

Roger: What if we just cash out entirely?

David: That’s probably a good idea, given the state of this market and the fact that the stock is selling so much higher than our target price. Like you always say, we can always re-enter later if we want and the yield is definitely a lot less now than the 10 percent floor of our Big Yield Hunting strategy.

Roger: Unfortunately, our two coal producer master limited partnerships have both taken a bath recently.

I can understand why investors would be less excited about coal miners with President Obama in for another four years than they would have been if Mitt Romney had won.

But come on! Haven’t we had this guy for four years already? What’s not to know about what he’s going to do? Yes, there are older coal-fired power plants in the US that are going to shut down–but because of low gas prices, not the president’s policies.

The Environmental Protection Agency effectively grandfathered every coal-fired power plant in the country from its carbon dioxide regulations. And in case people haven’t noticed, natural gas prices have been rising. In fact we’re seeing a number of power producers switch back to coal as the black mineral has become more competitive.

This is clearly an emotional selloff, and I think it’s setting up a huge opportunity in coal stocks. And let’s not forget both Natural Resources Partners LP (NYSE: NRP) and Rhino Resource Partners LP (NYSE: RNO) both covered distributions comfortably in the third quarter and were able to continue expanding as well.

Coal production from Natural Resources’ lands rose 11 percent in the third quarter, and its coverage ratio was 1.12-to-1. Rhino had a few more challenges with the Patriot Coal bankruptcy. But that was expected, and it also saw higher coal sales (up 8.3 percent) and cash flow was three times the distribution.

This group seems to be screaming value, and I think we need to stay with both of these positions.

David: I like the fact that both of these MLPs are conservatively run; that’s a huge factor in being able to sustain dividends.

I think we should also point out that MLPs are probably being sold off here, at least partly because of the rumor they’re going to be taxed as corporations next year.

Roger: I agree that seems to be the worry right now, though all the MLP tax breaks together cost Uncle Sam just USD300 million or so annually. That’s not going to make a dent on the budget, and it will curtail badly needed investment in energy midstream assets. MLPs also have a number of friends on both sides of the aisle.

But again, as we said before in this conversation, you can go broke pretty fast betting on politicians to do the smart thing. What I can say to investors is that if they buy well-run MLPs and a tax is announced, any resulting near-term losses from panic selling will be more than made up for down the road as they grow their businesses.

That was the experience with the Canadian income trusts, as you well know. Before we get to this month’s pick, which not coincidentally is an MLP play, let me ask you about our most recent Big Yield Hunting recommendation, Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF).

David: The stock is about where we picked it up last month. We did get some earnings numbers for the six months ended Sept. 30, and they were pretty much in line with what management has been guiding to.

The next dividend isn’t payable until June 2013, which gives management plenty of time to make up its mind on what to do. And in the meantime what happens to the Australian dollar is going to be important.

Roger: I like the Australian dollar over the long term, as you know, and this is a cheap stock.

Well, all this panic selling has definitely created a lot of deep value in the stock market, and there’s no shortage of big yields out there. What I like about my idea for this month is it not only pays monthly dividends and covers them well with cash flow. But it’s actually a closed-end mutual fund holding many of our favorite master limited partnerships, Cushing MLP Total Return Fund (NYSE: SRV), at a price of USD8 or lower.

Even if one of its holdings unexpectedly falters, there’s built-in diversification to pick up the slack.

David: That’s quite a departure for you recommending a mutual fund rather than an individual stock.

Does it bother you that we’re paying an expense ratio or that the fund trades at a premium to net asset value of 5 or 6 percent or so? We’re really spending USD1.05-plus to get a buck’s worth of assets.

Also, I see this fund is leveraged, carrying debt equal to about 36.3 percent of assets at this point. Won’t that multiply losses if there are dividend cuts at the individual holdings?

Roger: There are certainly better choices for safety. And no, I don’t like paying the premium or the expense ratio, though the premium is at its lowest point in quite some time after actually going over 30 percent this summer.

The leverage here, however, is another matter entirely. In fact I like Cushing precisely because it will give us a great deal of leverage when investors inevitably return to their senses concerning MLPs.

This fund has gotten bashed in bear markets but has an extraordinary record riding recoveries. I’m willing to buy it now because I think a few months from now this selloff in MLPs is going to look a lot more like what happened in 2011 rather than 2008.

If I’m wrong we’re going to be living with red ink for a while. But unlike the individual MLPs it holds, this fund’s broad diversification does ensure it will hold value.

Also, unlike a lot of funds it does cover its entire payout with investment income and then some, including expenses.

MLP prices are falling now. But distributions are still rising. In fact the fund’s top five holdings as of the end of September had increased distributions by average of 10.8 percent over the previous year.

Leverage does cut both ways. But this fund backs it up with a lot of safeguards, and the dividend just looks ridiculously high right now.

David: OK, sounds good. Buy Cushing MLP Total Return Fund up to USD8.

Let’s hope the next month brings a little more rationality to the market. But if not I guess we will have plenty of high-yield candidates to choose from.

Roger: True. As my son who studies Chinese tells me, the Middle Kingdom’s character for crisis combines danger and opportunity. And in this service anyway, we’re willing to take on the first for a shot at the second. Thanks David.

David: Thank you, Roger.

• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–SELL
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–SELL
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD20
• April 20, 2012: QR Energy LP (NYSE: QRE)–Buy < USD21
• May 17, 2012: Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF, ADR: TACBY)–Buy < USD3.15
• June 22, 2012: Data Group Inc (TSX: DGI, OTC: DGPIF)–SELL
• July 20, 2012: CSR Ltd (ASX: CSR, OTC: CSRLF)–SELL
• August 24, 2012: Natural Resource Partners LP (NYSE: NRP)–Buy < USD22
• September 21, 2012: Rhino Resource Partners LP (NYSE: RNO)–Buy < USD16
• October 19, 2012: Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF)–Buy < USD0.50
• November 16, 2012: Cushing MLP Total Return Fund (NYSE: SRV)–Buy < USD8

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–SELL
• October 22, 2010: Otelco (NYSE: OTT)–SELL (09/21/12)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–SELL (03/23/12)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)
• October 21, 2011: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–SELL (09/21/12)
• December 16, 2011: Telefonica SA (NYSE: TEF)–SELL (09/21/12)
• January 23, 2012: Inergy LP (NYSE: NRGY)–SELL (06/22/12)
• February 16, 2012: Arrium Ltd (ASX: ARI, OTC: ARRMF)–SELL (09/21/12)
• March 23, 2012: Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–SELL (06/22/12)