At last week’s San Francisco MoneyShow, attendees often asked me two questions: Are master limited partnerships (MLP) overvalued, and is it too late to buy into the group.

The Alerian MLP Index is up 18.5 percent in 2010, compared to a loss of more than 2 percent for the S&P 500. It’s only natural that investors would wonder if valuations for the group are stretched. In fact, it’s a downright healthy sign. Bull markets are always characterized by a large measure of skepticism; when greed takes over and bullish headlines abound, you know a top is in the making.

The short answer: Just because MLPs have performed well doesn’t mean they’re overvalued. But as always, it pays to be selective and patient. Here’s the long answer.

It’s All Relative

Ironically, a little over three months ago, attendees at the Las Vegas MoneyShow often asked why MLPs sold off so precipitously during the May Flash Crash, and whether a fundamental weakness was to blame.

These questions reveal a great deal about the extreme negativity that has permeated the market in recent months. Stocks just can’t seem to do anything right. When they sell off–as MLPs did in May–investors fret that underlying fundamentals may have deteriorated. When a group massively outperforms–as MLPs have in recent weeks–investors immediately question whether a bubble is forming. Unfortunately, the financial media perpetuates this fear by publishing sensationalist headlines that attract attention and score traffic on Internet search engines.

Because most investors buy MLPs for their distributions, partnerships are usually valued based on their yield relative to various historical averages. Most of the articles that argue MLPs are overvalued note that yields on many in the group are below their long-term averages. Let’s take a closer look at the five largest MLPs in the US by market capitalization.

Source: Bloomberg

These five MLPs are among the largest and oldest. The baby of the group, Conservative Portfolio recommendation Magellan Midstream Partners LP (NYSE: MMP), has about nine years of trading and distribution history. And because the big five account for about 40 percent of the Alerian MLP Index, they represent a good proxy for overall industry valuations.

The first column lists the average yield for each MLP since going public; the second column shows the current indicated yield. As you can see, each of these names currently yields less than their long-term average–all things equal, higher yields imply cheaper valuations. This is the basic argument posited by some recent articles about MLP valuations: Because MLPs offer lower-than-average yields, they must be too expensive.

But this argument has little meaning because the interest-rate environment has changed markedly over the period in question. We now live in a low-yield world. The yield on 10-year US government debt stands at around 2.6 percent, compared to more than double that level a decade ago. Yields on essentially risk-free bank savings and money market accounts hover near 1 percent, compared to 5 percent 10 years ago.

It makes little sense to compare the yield on income-producing assets today with those of a decade ago; a 6 or 7 percent yield is a lot more valuable for an income investor today than it was in 2000 and or in the early 1980s when interest rates were closer to 20 percent. There’s no free lunch: Investors can’t obtain the high yields of 10 years ago without assuming considerably more risk.

Income investors should compare an MLP’s yield to that of the 10-year Treasury note. Because the market regards the 10-year note as a risk-free investment, the relative yield reveals how much investors are compensated for taking on additional risk.

This more relevant metric suggests that MLPs are still cheap. Check out the table above. The “Current Spread” column lists the indicated yield for each MLP, minus the current yield on a 10-year Treasury note. “Average Five-Year Spread” shows the average relative yield for each MLP since it went public.

For example, Portfolio bellwether Enterprise Products Partners LP (NYSE: EPD) has offered an average yield spread of 2.73 percent (273 basis points) but now yields 3..57 percent more than the 10-year Treasury note. That is, investors are being paid more than average to hold Enterprise Products Partners.

Income Growth

One could argue that US government rates are near all-time lows, so relative yields aren’t as meaningful. But we can also compare MLPs’ yields to those offered by corporate bonds and real estate investment trusts (REIT).

These comparisons also suggest that MLPs trade at reasonable valuations. For example, check out this graph comparing Enterprise Products Partners’ yield to that of the largest REIT in the Bloomberg REIT Index, Simon Property Group (NYSE: SPG).

Source: Bloomberg

At present, units Enterprise Products Partners yield 6.2 percent, nearly 4 percent more than Simon Property. That’s nearly twice the average spread since 1999.

And the MLP has boosted its payout for 24 consecutive quarters and has never cut its distribution. Simon Property Group, on the other hand, cut its dividend in 2009. Over the past five years, the REIT’s total dividends have declined 6.1 percent annualized; Enterprise Products Partners increased its payout 6.8 percent annualized over this period.

This table also serves as a reminder that investors shouldn’t make decisions solely based on yield. Although relative yields are a useful valuation metric, a business’ underlying fundamentals are paramount. Simplistic arguments about overvalued MLPs tend to gloss over this point.

Consider that many mortgage REITs and financials looked cheap on a yield basis back in 2008, before the financial crisis devastated the market. Many of these high-yielders are no longer solvent, while others were forced to slash their dividends to conserve cash. A high yield is a value trap if it’s not sustainable.

In contrast, investors are willing to pay up for consistently growing payouts. Some MLPs have lower yields today because investors expect the payout to grow significantly in coming quarters.

This is another fundamental reason MLPs have outperformed this year; distribution growth prospects are improving rapidly. The final three columns of my table show the one-year historic distribution growth, the five-year annualized historic growth, and the consensus estimates for annualized distribution growth over the coming three years.

As you can see, all of the MLPs on the table, with the possible exception of Enterprise Products Partners, slowed their distribution growth over the past year.  For example, Kinder Morgan Energy Partners LP (NYSE: KMP) has averaged annual distribution growth of 7 percent over the past five years but grew its payout just 2.2 percent over the past year. Although none of these MLPs cut distributions during the downturn, most chose to be conservative about increasing their quarterly payouts.

But that’s changing. Debt and equity markets have improved dramatically since the middle of 2009; as we’ve pointed out on multiple occasions over the past year, quality MLPs have been able to raise capital cheaply to fund expansion projects or acquisitions. These new growth-oriented projects are beginning to show up in the form of distribution growth. Four of the five MLPs in the table are projected to boost their payouts at a faster pace over the next three years than they have over the past 12 months.

MLPs aren’t as cheap as they were at the height of the financial crisis in late 2008 and early 2009. But with better-than-average yields relative to most other classes of income investments, accelerating distribution growth prospects and significant tax-deferral advantages, the group isn’t overvalued.   

Rather than trying to come up with some elusive “fair” valuation for the Alerian MLP Index as a whole, we prefer to analyze the group the old-fashioned way: By scrutinizing each partnership individually and evaluating its growth prospects, risk and reward. Over the past four issues of MLP Profits, we’ve given a detailed review of every one of our recommended holdings and the underlying risks.

Based on this assessment, we establish a “buy” target for all of our recommendations. We revise this advice as fundamental conditions warrant. We have also instructed subscriber to sell Portfolio holdings that vastly exceed a reasonable valuation. We will also recommend that you sell if the underlying business begins to falter.

As Roger pointed out in the Aug. 16, 2010, issue Betting to Buy Low, we firmly believe that investors who buy MLPs under our targets will generate solid long-term income and build wealth. Roger also highlighted buying strategies that investors should follow.

Portfolio News

August is usually a quiet, low-volume month for the stock market; with second-quarter results largely in the rearview mirror, the newswires have slowed to a crawl.

Nonetheless, three of our portfolio recommendations have announced that they’re issuing new units to raise capital–a golden opportunity to buy well-placed MLPs at discounted prices. Here’s a rundown of the latest deals. 

 EV Energy Partners LP (NasdaqGS: EVEP) has completed its planned offering of 3 million additional units at a price of $33.97 per unit. The underwriters of the deal have exercised their over-allotment option for an additional 450,000 units at the same price, bringing the total value of the deal (net of costs) to just under $115 million. These funds will ultimately be used to finance the partnership’s recent acquisition. (See Betting to Buy Low.)

Units of EV Energy Partners have traded lower since the secondary offering was announced–a normal, knee-jerk reaction. But sellers fail to consider that the deal won’t be dilutive because EV is using the proceeds to buy new assets that will be immediately accretive to cash flow. And higher cash flow ultimately spells rising distributions.

After the recent dip EV Energy Partners LP is back below our buy price of 34, offering investors a chance to buy at an attractive price.

Conservative Portfolio Holding Sunoco Logistics Partners LP (NYSE: SXL) announced a secondary offering of 1.75 million units, with a potential over-allotment option of 262,500.

Although the MLP will use the proceeds to pay down debt, that’s likely a temporary solution. The refined products pipeline and storage MLP has made a series of small bolt-on acquisitions in recent weeks and has several organic expansion projects in the works. It makes sense to raise capital right now to fund these projects; all will be quickly accretive to distributable cash flow.

Sunoco Logistics is still above our buy target of 70, but investors should buy it on any dip below that level.

Finally, Energy Transfer Partners LP (NYSE: ETP) announced that it will issue 9.5 million common units at a price of $46.22 per share. The MLP plans to use the proceeds to fund the construction of several new pipelines and related infrastructure–for example, the recently expanded Tiger Pipeline project that will transport gas from the prolific Haynesville Shale. This pipeline is already fully contracted, meaning that Energy Transfer Partners has already lined up customers willing to pay guaranteed minimums just to gain access to capacity on the pipe.

Issuing new units to build a pipeline that will begin generating cash next year is hardly a dilutive move for existing unitholders. After several weeks above our buy target, this news offers investors an opportunity to snap up units of Energy Transfer Partners LP under 48.

Editor’s Note: For additional information on this topic, check out the latest report about Master Limited Partnerships written by Roger Conrad and Elliott Gue.