What Group Consistently Beats the S&P 500, Pays Out Cash Like Crazy?

Investors seeking income in a world of declining bond returns have set off a flurry of buying in master limited partnerships (MLPs), companies that essentially pay high dividends to investors who agree to pay their taxes. As a group, MLPs have a very strong long-term record of outperforming the overall market on share price gains. And at the moment, some of the popular picks are offering yields ranging from 4% to 7%.

AMJ Chart

AMJ data by YCharts

Last year was the first in more than a decade that the JP Morgan Alerian MLP Index (AMJ) didn’t outperform the S&P 500. MLP share prices dropped late in 2012 on worries that fiscal cliff negotiations would mess with their beneficial tax structures, which allow them to avoid certain corporate taxes.

But those concerns faded, and the shares came roaring back this year. That MLP index has outperformed the S&P 500 by about 3.5 percentage points so far, helped in part by major pension funds that started picking up the shares. Dozens of new MLPs launched in the past few years, and investment houses have several new exchange traded funds focusing on MLPs this year alone.

Picking MLPs for investment starts with identifying your preferred industry. All MLPs are energy or commodity related companies in businesses like oil and gas transmission or refining, fertilizers and mining. Late last year, the IRS allowed that plants that process natural gas liquids into chemicals can also be MLPs. Cash flow is the critical component for investors; it determines the yield, as they are required to pay out most of their cash to partners (MLP code for shareholders) quarterly.

Investors in certain well-positioned pipeline, storage and refining MLPs made out like bandits in recent months as a shortage of these things to service domestic natural gas shale fields brought them lots of business. Shares of terminals company Sunoco Logistic Partners (SXL), for example, rose 65% in the past year; 71% if you consider its distributions (dividends, MLP-style). Sunoco’s yield has dropped to 3.5%, however, and now there’s more positive Wall Street chatter about pipeline and storage company Enterprise Products Partners (EPD), which currently yields 4.7%; and Genesis Energy (GEL), a small, Houston-based refining and transporting operation with a current yield of 4.15%.

EPD Free Cash Flow TTM Chart

EPD Free Cash Flow TTM data by YCharts

Some MLPs are expected to produce relatively steady-growing payouts, while others have good and bad years by their nature. MLPs whose cash flow fluctuates with the price of a commodity, like miners, will have more volatile returns than others that are paid on volume, like pipeline companies. A lot of the newer MLP funds are of the more variable returns. Charts of historic distributions (dividends) help investors see which camp they fall in. Fertilizer MLP Terra Nitrogen (TNH) offers a 7.3% yield now, but you can see the volatility in the payout next to pipeline MLPs like Plains All American Pipeline (PAA) and Magellan Midstream Partners (MMP), both yielding 4.1%.

TNH Dividend Chart

TNH Dividend data by YCharts

Generally, oil and natural gas liquids gas related companies are popular now, like pipeline company Williams Partners (WPZ), with its 6.8% yield, and liquids processing company Targa Resource Partners (NGLS), with a 6.2% yield. That’s of course a gross generalization of an extremely complicated field. Geography weighs heavily on many MLPs’ fortunes. Taxes on the distributions will wipe out benefits of the higher yields for certain investors. Tax reporting involves collecting a K1 from each company, which is why a lot of MLP investors prefer to own them in an exchange traded fund that creates a single 1099.

But income is a rare and coveted thing for a lot of investors today, and there are only so many dividend-paying large caps a diversified portfolio should hold. MLPs offer a variety of options for keeping those payments flowing.

Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at editor@ycharts.com.

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