All too often, investors in master limited partnerships (MLP) gravitate toward the highest yielding fare, assuming that the underlying businesses will be able to sustain their generous payouts for some time.

Not surprisingly, readers often ask us about marginal names that we track in How They Rate such as the sell-rated America First Tax Exempt Investors LP (NSDQ: ATAX), Calumet Specialty Products Partners LP (NSDQ: CMLT), Cheniere Energy Partners LP (AMEX: CQP), KKR Financial Holdings LLC (NYSE: KFN), StoneMor Partners LP (NSDQ: STON) and Terra Nitrogen LP (NYSE: TNH).

With the exception of Terra Nitrogen, having a big yield hasn’t helped any of these MLPs generate a positive return in 2011. And most of Terra Nitrogen’s gains stem from the partnership’s growing distribution, the result of strong demand for nitrogen and fertilizer products and services.

High, tax-advantaged distributions can line MLP investors’ pockets. But distributions alone have accounted for only a third of Alerian MLP Index’s total return since we launched MLP Profits in summer 2009. Capital appreciation has driven total returns over that period. Distribution growth has been the primary driver of the surge in MLP unit prices.

Don’t Go for Broke; Go for Growth

The names in our model Portfolios all boast growing businesses that will generate sustainable distribution growth.

To be sure, we’re taking a calculated risk with several picks that feature extraordinarily high yields. Those bets, however, are grounded in our view that investors’ perception of risks to their distributions is overblown. In general, our riskier plays have generally maintained their distributable cash flow (DCF) in this difficult economic environment; unit prices should rally sharply when the gloom overhanging the market lifts even a little.

Dividend paying equities–including MLPs–stopped following the ups and downs of interest rates several years ago. Check out this graph comparing the Alerian MLP Index to the 10-Year Yield Index.

Source: Bloomberg

Instead, they track dividend growth over the long term and investors’ perception of risk in the near term. The greater the perceived risk to a partnership’s payout, the further the MLP’s units will sink when macro risks spook investors. By the same token, our riskier Portfolio holdings also have more room to rally when investor sentiment improves.

Our two highest-yielding picks are Aggressive Portfolio holding Navios Maritime Partners LP (NYSE: NMM) and Growth Portfolio holding Inergy LP (NSDQ: NRGY), which Elliott reviewed in the Nov. 21 article, Still Paying Their Way. 

Investors continue to await more details on announced plans to spin off Inergy’s midstream energy assets and the implications of this move for the distribution. Meanwhile, insiders have stepped up to the plate, purchasing 5.65 million units in November.

We continue to rate Inergy a “hold,” taking a calculated risk that management will be able to weather the difficult conditions in the propane distribution business and maximize the value of the midstream assets. Management’s guidance for fiscal 2012 DCF doesn’t cover the current payout, leaving little margin for error. Although management has confirmed that Inergy will maintain its current quarterly payout, borrowing from the firm’s credit facility to pay the distribution isn’t a sustainable long-term strategy.

If the management’s plan to right the ship works out, the stock could rally to about $35. A distribution cut shouldn’t cause the unit price to collapse; at these levels, the stock has arguably discounted such an outcome. In the meantime, expect this high-yielding stock to suffer worse volatility than the names in our Conservative Portfolio.

Units of Navios Maritime Partners currently yields well over 12 percent after stock tumbled from a record high of more than $21 in late April 2011. This recent swoon belies the company’s strong performance this year and two distribution increases over the past 12 months. (See The Unbroken Bull from Oct. 28, 2011.)

Investors remain bearish on Navios Maritime Partners for two reasons. For one, conditions in the tanker industry continue to deteriorate, as demonstrated by General Maritime Corp’s (NYSE: GMR) recent bankruptcy. Although General Maritime owned oil tankers and Navios Maritime Partners focuses on dry-bulk carries, day-rates have plunged in both industries because of overcapacity.

Day-rates in the spot market, where vessels are immediately available for short-term leases, are well below rates on expiring contracts. General Maritime Corp, for example, reported a 52.8 percent drop in third-quarter spot rates from a year ago and a 34.1 percent decline in its “net voyage revenue.” Meanwhile, a decline in vessel values required the ailing company to make prepayments on some its loan covenants, leading to 46.1 percent in interest expenses.

Navios Maritime Partners LP’s third-quarter results showed little effect from the brutal operating environment. Revenue rose 26 percent from year-ago levels, cash flow surged 24.1 percent, and “operating surplus”–the account from which distributions are paid–increased 24.1 percent. The MLP covered its third-quarter distribution 1.6 times.

The difference maker continues to be management’s conservative financial and operating policies. Navios Maritime Partners’ fleet has an average of more than four years remaining on its outstanding charters. The company’s vessels are under contract on 92 percent of available days in 2012. These agreements are insured against default by an AA+ rated EU governmental agency, which has already made good on one defaulted contract.

Meanwhile, investors are skeptical of any company that relies on the EU government, as well as any firm headquartered in Greece. Investors also fret that the weak global economy will further worsen supply and demand conditions in the shipping market.

Nevertheless, as Navios Maritime Partners’ CEO by CEO Angeliki Frangou noted during the company’s Oct. 24 conference call, dry-bulk shipping rates have shown signs of recovery and major ports for shipping coal, iron ore and other materials are congested. Frangou also indicated that “scrapping is setting new records on a deadweight basis.”

Our bet on Navios Maritime Partners assumes that the company will continue to perform in a difficult operating environment. We’ll continue to monitor the MLP’s results to ensure that the business is generating enough cash flow to support the distribution. With little exposure to depressed rates in the stock market over the next few years, Navios Maritime Partners rates a buy under 20.

Our other Portfolio holdings offer lower yields than Inergy and Navios Maritime Partners because the perceived risk to their distributions is lower.

Units of Conservative Portfolio holding Sunoco Logistics Partners LP (NYSE: SXL), for example, have eclipsed $100 and yield less than 5 percent. Magellan Midstream Partners LP (NYSE: MMP) also yields less than 5 percent. Taken together, the six Conservative Portfolio holdings currently yield 5.6 percent–almost 7 percentage points less than units of Navios Maritime partners.

Even as many investors have run from Inergy and Navios Maritime Partners, they’ve poured money into safer MLPs. We remain bullish on all six of our Conservative Portfolio holdings, all of which boast strong distribution coverage and low debt. These picks also generate a much of their DCF from reliable fee-based income streams and continue to grow their distributions. Check out “By the Numbers.”

Source: Bloomberg, MLP Profits

Each of these MLPs earns full marks–a “4” rating–under our proprietary Safety Ratings system. These conservatively run MLPs represent a safe haven for investors and will continue to outperform in these uncertain times.

On the other hand, no dividend-paying stock is a value at any price. Units of Conservative Portfolio holdings Enterprise Products Partners LP (NYSE: EPD), Kinder Morgan Energy Partners LP (NYSE: KMP), Magellan Midstream Partners LP and Sunoco Logistics Partners all trade above our buy targets.

Over the long haul, even these MLPs should follow their distribution growth to new highs. But we’ve set our buy targets with total returns–distributions plus projected price appreciation in mind. If you overpay, your returns will be diminished. Don’t be tempted to chase high-quality MLPs when their unit prices top our buy targets, especially when volatility rules the tape.

The best strategy is to build a balanced portfolio of MLPs that best fit your risk profile. If you’re looking for a reliable income, stick mostly with our Conservative Portfolio holdings. If you can take a bit more risk in pursuit of growth, add some higher-yielding fare to the mix. Above all, don’t put all of your eggs in one or two baskets. Even the strongest MLPs can stumble, while the weakest can sometimes shine under the right circumstances.

More Numbers

Here’s the rundown on third-quarter results from six Portfolio holdings: DCP Midstream Partners LP (NYSE: DPM), Encore Energy Partners LP (NYSE: ENP) Energy Transfer Partners LP (NYSE: ETP), Enterprise Products Partners LP (NYSE: EPD), Genesis Energy LP (NYSE: GEL) and Regency Energy Partners LP (NYSE: RGP)

Genesis Energy LP (NYSE: GEL)

Conservative Portfolio holding Genesis Energy has boosted its payout in 25 consecutive quarters. The most recent hike to the MLP’s distrbution marked the 20th time the partnership had hiked the dividend at an annualized rate of at least 10 percent. More important, the company”s available cash before reserves (a similar measure to DCF) covered the increased distribution by a solid 1.2-to-1 margin.

The company locked in future growth in its mostly fee-based income by announcing the acquisition of interests in several crude oil pipelines, as well as with continued construction of terminals and trucking assets that are expected to be operational in the first quarter of 2012. Current plans will expand crude oil trucking operations by 40 percent, with plenty of room for further growth down the road.

The acquisition of ownership interests in several crude-oil pipelines and the construction of new terminals and trucking assets should enable the company to grow its fee-based income in 2012. Current plans will expand Genesis Energy’s oil trucking operations by 40 percent, while demand suggests the company could add more capacity down the road.

Income before taxes (segment margin) in the MLP’s pipeline transportation division climbed 34.5 percent from year-ago levels, bolstered by a solid operational performance and asset expansion. Supply and logistics, which leverages the company’s tangible assets, enjoyed a 68.3 percent surge in income before taxes, while refinery services’ segment margin jumped 10.9 percent. All three operating segments contributed roughly equally to the company’s third-quarter income.

Speaking at an RBC Capital Markets’ MLP Conference in mid-November, Genesis Energy’s CEO Grant Sims reminded investors that the MLP has “permanently eliminated incentive distribution rights (IDRs)” to its general partner (GP). This move lowered the distribution coverage ratio in the third quarter, as Genesis issued more units as compensation to the GP. But in the future, all cash flow growth will be disbursed to common unitholders.

The MLP has no debt maturities until its $775 million credit agreement comes up for renewal on June 30, 2015. The company currently has $367.9 million drawn, leaving plenty of funds for acquisitions or organic growth projects.

Genesis Energy has almost doubled its distribution since the stock peaked at $36 in mid-July 2007. Since the 2008-09 meltdown, the unit price hasn’t breached $30, possibly because of the company’s small market capitalization and focus on less-known niches in the energy business.

As long as the MLP continues to grow its payout, the stock eventually should break above $30 per unit. Yielding 6.5 percent, units of Genesis Energy LP rate a buy up to 28.

Enterprise Products Partners LP (NYE: EPD)

Units of Conservative Portfolio holding Enterprise Products Partners LP trade just above our buy target after hitting a record high in late November. The stock has dipped below $40 on numerous occasions in 2011; investors looking to establish or build their positions in Enterprise Products Partners should be patient for another dip. But that’s about the only thing negative to say about this cornerstone holding.

In mid-October 2011, management announced the 29th consecutive quarterly distribution increase and the 38th time the payout has been hiked since the MLP’s initial public offering in 1998. Enterprise Products Partners’ third-quarter DCF covered the new quarterly disbursement of $0.6125 per unit–a 5.2 percent increase from a year ago–by a virtually unassailable 1.7-to-1 margin.

Third-quarter results announced earlier this month reflect the strong performance of existing assets, many of which benefited from inflation-indexed rate increases. The MLP also continues to grow DCF by expanding existing assets and buying and building new ones.

At a market capitalization of almost $40 billion, Enterprise Products Partners pales in comparison to the size of many of its customers. But the MLP has become the biggest player in the midstream energy space and has leveraged this size to quickly build its footprint in some of the nation’s hottest, oil- and liquids-rich shale plays.

Enterprise Products Partners generated DCF of $856 million in the third quarter, up 49.4 percent from a year ago. DCF excluding one-time items such as asset sales still covered the distribution by 1.3 to 1. Liquids pipeline volumes were 3 percent lower than a year ago. However, throughput on the MLP’s gas pipelines jumped 5 percent, while the firm fractionated 16 percent more volumes natural gas liquids (NGL). Fee-based gas processing volumes also surged 40 percent from the third quarter of 2010.

The MLP forked out $1.1 billion in capital expenditures during the quarter, including $81 million in maintenance expenditures.

Pipeline safety has come under increasing scrutiny after well-publicized leaks at assets owned by Enbridge (TSX: ENB, NYSE: ENB) and others. Although no pipeline owner is immune from potential problems, Enterprise Products Partners has fared well thus far, responding quickly to weaknesses in its own system. For example, the company this week announced that it isolated a leak on its Seaway oil pipeline in Fulshear, Texas, ensuring that “the spill was confined to the vicinity of the pipeline.”

Enterprise Products Partners is investigating what caused the leak in the 500-mile pipeline that links the Gulf Coast to Cushing, Okla, the delivery point for West Texas Intermediate crude oil. Management has emphasized that the leak and subsequent repairs will have only a “negligible” impact on shipping volumes. The company plans to reverse the flow of the Seaway pipeline to bring crude oil from the bottlenecked Cushing hub to refineries on the Gulf Coast.

Meanwhile, Enterprise Products Partners has a full slate of growth projects that will come online in coming years. These endeavors include a plan to expand the MLP’s NGL export capacity by 50 percent in 2012 and the now operational extension of the Acadian Gas Pipeline System in Louisiana, the firm’s largest capital project to date.

Buy Enterprise Products Partners LP when the units dip below 45.

DCP Midstream Partners LP (NYSE: DPM) 

Growth Portfolio holding DCP Midstream Partners LP has raised its distribution in four consecutive quarters for a total increase of 4.9 percent. The MLP owns a mix of fee-based assets and in November assumed full ownership DCP Southeast Texas Holdings via a $165 million drop-down transaction with its GP, DCP Midstream LLC.

The deal increased the general partner’s stake in DCP Midstream Partners to 20 percent, while the MLP gained all cash flows from a 900-mile system of gathering and transportation pipelines with throughput of about 550 million cubic feet of natural gas equivalent per day. The acquisition is expected to close in the first quarter of 2012 and will be immediately accretive to cash flow.

Third-quarter results weren’t impressive at first blush because of one-time events such as planned turnaround activity, environmental remediation and the timing of certain expenditures. Nevertheless, the results were in line with management’s forecast. With a 12-month distribution coverage ratio of 1.1 to 1, DCP Midstream Partners has the scope to announce another dividend increase in January 2012.

DCF growth in 2012 hinges on the expansion of NGL-related assets, especially storage and fractionation facilities. As we noted in the Saudi Arabia of Natural Gas Liquids, demand for NGL-related infrastructure should continue to grow as rising production from shale fields prompts petrochemical companies to take advantage of attractive feedstock prices by expanding their US manufacturing operations. Exports of certain NGLs have also ratcheted higher.  

DCP Midstream Partners’ GP this fall increased an offering of 10-year bonds to $500 million from $400 million at an interest about 275 basis points above 10-Year Treasury bonds–a testament to the strength of the MLP. DCP Midstream Partners also secured a five-year, $1 billion credit line in November 2011, replacing an $850 million line set to mature in June 2012. The new facility can be upsized to $1.25 billion to fuel acquisitions or expansion opportunities, including additional asset drop downs from the parent and general partner.

Units of DCP Midstream Partners trade above our buy target, but volatility in the stock market should afford patient investors additional buying opportunities. Buy DCP Midstream Partners LP under 40.

Energy Transfer Partners LP (NYSE: ETP)

Fellow Growth Portfolio holding Energy Transfer Partners LP continues to trade well below our buy target for two main reasons.

First, the company has not increased its distribution since 2008, reflecting a bias toward investing in growth projects. Management has repeatedly promised a distribution increase this year but has yet to deliver. In fact, the MLP won’t declare its next dividend until January 2012.

The second reason the MLP sells at such a discount to its peers–and sports a yield of more than 8 percent–is the uncertainty surrounding general partner Energy Transfer Equity LP’s (NYSE: ETE) attempt to acquire natural-gas pipeline owner Southern Union (NYSE: SUG). If Southern Union shareholders vote to approve the deal on Dec. 9, 2011, Energy Transfer Partners will receive a 50 percent interest in a Florida pipeline at a cost of roughly $2 billion.

Now that the influential Institutional Shareholders Services has advised shareholders to approve Energy Transfer Equity’s takeover of Southern Union, the deal should go through; institutions hold 71.8 percent of Southern Union’s outstanding shares.

Energy Transfer Partners’ planned sale of its propane distribution operations to AmeriGas Partners LP (NYSE: APU) for $2.9 billion should go a long way to covering the tab on the drop-down of the Florida pipeline. Either Energy Transfer Partners or its GP could sell assets to Williams Companies (NYSE: WMB), which lost out in a bidding war for Southern Union.

Energy Transfer Partners also sold 13,250,000 new units at a price of $44.67 per share in mid-November, raising roughly $592 million before fees.

Until these deals go through, expect the units of Energy Transfer Partners to lag its peers. Investors also shouldn’t expect any meaningful distribution increases until the deal closes.

On the plus side, the MLP finally posted the breakthrough third-quarter results management has guided for all year. DCF soared by 152 percent in the third quarter, pushing nine-month cash flow up 10.9 percent above last year’s tally and erasing shortfalls in prior quarter.

DCF per unit came in at more than $1.27, covering the quarterly distribution by a 1.42-to-1 margin. The key contributors were the Tiger and Fayetteville Express pipelines, which are rapidly growing cash flow as contracts start to kick in.

The company’s NGL assets are also produced as never before and will expand once the joint venture with affiliated MLP Regency Energy Partners comes onstream. The gas storage business weakened in the third quarter because of lower fee-based revenue and lower margins on physical sales. Operating income from the company’s midstream assets climbed 40 percent from a year ago, while NGL production grew 7 percent from the acquisition of assets in the Eagle Ford Shale.

In the fourth quarter, Energy Transfer Partners will spend between $450 and $530 million on growth investments. The 2012 capital budget calls for another $1.3 billion to $1.5 billion in expenditures, excluding the cost of acquiring a 50 percent stake in the owner of the Florida Gas Transmission pipeline system.

These high-quality projects are backed by capacity agreements with creditworthy customers and should generate reliable cash flow regardless of the direction of energy prices and the economy.

In turn, higher cash flows eventually will translate into distribution growth and unit price appreciation. Energy Transfer Partners LP is an excellent value under 50.

After the their recent swoon, units of Energy Transfer Equity yield more than 7 percent. Unlike Energy Transfer Partners, the GP has increased its distribution twice this year. The most recent announcement boosted the payout to 62.5 cents per unit, up 15.7 percent from last year. Energy Transfer Equity LP, which we track in How They Rate, is a buy up to 40 for investors willing to sacrifice some yield and take on more risk in return for distribution growth and potential price appreciation.

Regency Energy Partners LP (NYSE: RGP)

Energy Transfer Equity also owns the general partner interest in Aggressive Portfolio holding Regency Energy Partners LP. After a long dry spell in which the MLP didn’t raise its distribution, Regency Energy Partners hiked its August and November disbursements, increasing the payout 2.3 percent from a year ago.

Third-quarter cash climbed 25 percent, largely because of cash flow generated by Regency Energy Partners’ Lone Star joint venture with Energy Transfer Partners. Throughput on its gathering and processing system in west Texas also increased.

Regency Energy Partners is also involved in the Midcontinent Express Pipeline venture operated by Conservative Portfolio holding Kinder Morgan Energy Partners. The MLP runs the Haynesville Joint Venture, which remains highly profitable despite a 20 percent decline in volumes from last year.

Although Energy Transfer Equity’s acquisition of Southern Union could yield a major drop-down transaction for Regency Energy Partners, the Aggressive Portfolio holding already has plenty of potential growth projects on its plate. The MLP invested $258 million in growth capital projects in the first nine months of 2011, of which $172 million went to the gathering and processing segment.

Full-year plans call for the firm to spend $373 million on organic growth, including $65 million to fund Regency Energy Partners’ stake in the Lone Star NGL project. Management expects capital expenditures to roughly double to between $630 and $680 million in 2012. About $250 million to $300 million will be allocated to Lone Star.

Excluding the issue of 11.5 million common units in October 2011, distribution coverage in the third quarter was a reasonable 1.06-to-1. That’s not enough for Regency Energy Partners to earn a top safety rating. Nevertheless, the MLP can maintain the current payout, and growth measures should lead to higher distributions in 2012 and beyond.

Regency’s affiliation with Energy Transfer Equity explains why the units continue to trade well below their July 2007 high. But the MLP continues to execute its growth strategy, and there’s the possibility for an accretive merger down the road as Energy Transfer Equity consolidates its various interests to cut capital costs and speed.

Buy Regency Energy Partners LP up to 29.

Encore Energy Partners LP (NYSE: ENP)

Aggressive Portfolio holding Encore Energy Partners LP will finally merge with Vanguard Natural Resources LLC (NYSE: VNR). Investors should soon receive 0.75 units of Vanguard Natural Resources for each unit of Encore Energy Partners they own. No action is required on your part, though you may want to check with your broker to ensure the transaction was executed smoothly.

The deal amounts to a slightly lower payout for investors in Encore Energy Partners. On the other hand, Vanguard Natural Resources has hiked its payout for four consecutive quarters, increasing the payout by 5 percent from a year ago. Third-quarter DCF surged 31 percent in the third quarter, covering the MLP’s increased distribution by a solid 1.09-to-1 margin.

Production volumes soared 163 percent from the third quarter of 2010, with liquids accounting for 65 percent of total output and natural gas accounting for the remaining 35 percent.

Encore Energy Partners likewise derived 62 percent of its production from liquids in the third quarter, but its output increased only 4.2 percent. In the first nine months of 2011, Encore Energy Partners output fell 1.9 percent from the prior year.

We Vanguard Natural Resources’ management team extract more value from Encore Energy Partners’ asset base and grow production. Improved scale and a simplified capital structure will also help. The management team at Vanguard Natural Resources is also familiar with Encore Energy Partners’ acreage because of the firm’s existing stake in its acquisition target.

We’ve made a modest return on our position in Encore Energy Partners since we added the stock to the Aggressive Portfolio in April 2010–an impressive feat given the turbulence in the stock market and two distribution cuts.

We expect to do considerably better now that Encore Energy Partners has been subsumed by a well-capitalized and well-managed operator.

Note that this equity-for-equity deal won’t add to Vanguard Natural Resources financial burden, aside from debts assumed from Encore Energy Partners. These obligations consist primarily of $346 million in borrowings on a $475 million credit line that matures on March 7, 2012.

Vanguard Natural Resources also has a $175 million loan maturing Dec. 31, 2011, which the firm will have to roll over or pay off. The company, however, also has a $1.5 billion credit agreement that’s not up until Oct. 31, 2016.

After the merger, the combined company is expected to generate enough DCF to cover its distribution 1.4 to 1.45 times. These estimates are based on conservative forecasts for oil and gas prices.

With solid growth prospects even before the purchase of Encore Energy Partners, Vanguard Natural Resources LLC joins the Aggressive Portfolio as a buy up to 30.